Euro area inflation is lower, but the ECB should not change its view

Following the latest decline in the oil prices, the euro area inflation forecast has been down to 0.1% from 0.2% in 2015 and to 1.2% from 1.4% in 2016. Updated projection does not include a new period of deflation, but it is on the borderline as it is expected that, inflation will decline to 0.1% in August and further down to 0.0% in September.

Later this year, it is expected that, there will be a considerable increase in headline inflation as base effects from the sharp decline in the oil price at end-2014 will lift energy price inflation. Even in a scenario where the oil price stays around the current low level inflation is set to increase by around 1 percentage point within four months.

"We forecast an increase in inflation from 0.2% in October this year to 1.3% in January 2016. Compared to our previous forecast, the level of inflation will thus be lower at the end of the year, but it should still increase fast", says Danske Bank.

The considerable increase in inflation of around 1pp within four months is likely to attract attention among market participants at the end of this year. This is especially likely to be the case in an environment where the oil price remains fairly low and in light of this, fixed income markets could be sensitive to a fast increase in headline inflation.

The ECB will release new inflation projections at the upcoming ECB meeting on 3 September and a downward revision is expected in 2015 and 2016 forecasts compared to the latest projections from June. A lower forecast should primarily be driven by a lower energy price inflation forecast, as the ECB in the previous projections from June had an average oil price of USD63.8/bl in 2015 and USD71/bl in 2016.

The lower oil price will not result in a change to an even more accommodative monetary policy from the ECB. It is  believed that, ECB will stick to its view that the QE programme has implied a limited impact on wages from secondround effects driven by the oil price and related to this that core inflation needs to go lower again before the ECB will change its view. It will be interesting to follow the ECB's inflation forecast for 2017, which could be kept unchanged at 1.8% or lowered slightly to 1.7%.

"We still see the ECB's forecast for core inflation in 2016 as too optimistic and at a later point in time we believe it will lower its forecast. As core inflation has recently jumped from its historical low of 0.6% in April to 1.0% in July, we believe it is too early for the ECB to revise its forecast for 2016 lower. This should follow even though we expect core inflation to decline back to 0.9% in August", notes Danske Bank.