Today’s flash estimate for eurozone Harmonised Index of Consumer Prices (HICP) inflation came in at 1.8% year-on-year, a jump from 1.1% in December. But while headline inflation could rise further over the next few months, we see scant evidence of a pickup in core inflation – a measure that excludes energy and food prices, the key drivers of the recent HICP gains.
HICP trending up
The widely expected rise in HICP primarily reflected higher oil prices after a sharp drop between December 2015 and January 2016. We’ve seen a similar effect in the unprocessed foods sector, where prices were weak at the beginning of 2016 due to an unusually warm winter but now face upward pressure amid much colder temperatures this year.
We expect these forces to continue through April, pushing HICP inflation through 1.8%. Thereafter the effects will likely fade, and inflation should drop back to about 1.5%, remaining stable around that level for the rest of the year.
Core inflation remains sluggish
In terms of European Central Bank (ECB) policy, the rate to focus on is not HICP but core inflation, which has increased only marginally in recent months. Given the absence of either strong wage or credit growth in the eurozone, core inflation is unlikely to move much from its current level of 0.9% in 2017 and will probably end the year at around 1.1%.
While higher headline numbers could put some pressure on the ECB, the bank is unlikely to alter its monetary policy stance much so long as core inflation remains muted. However, the markets could price in an earlier-than-expected normalization of policy, which might lead to a tightening of financial conditions– possibly too early for an economy facing sluggish core inflation for the foreseeable future.
In short, we see little probability of high core inflation rates in the eurozone, but instead a gradual increase toward the ECB target of just below 2% over the next few years. However, there is still a risk that a rise in inflation in the U.S. under the new Trump administration could ripple out to Europe. Investors with unhedged inflation risks would be wise to think about potential strategies for protecting their portfolios.
Michael Althof is a PIMCO portfolio manager focusing on real return strategies.