Eurozone likely to witness steady recovery this year, inflation to sharply pick up

The eurozone economy is expected to witness a steady recovery this year but with downside risks on an unfavourable external environment, including post-Brexit uncertainty. Expectations of a sharper pick-up in 2017-18 inflation is mainly reflective of a rise in the ECB’s oil price assumptions and unfavourable base effects.

The European Central Bank (ECB) left key benchmark rates and the asset purchase program unchanged yesterday, in line with our expectations. The central bank nonetheless reiterated its ability, willingness and capacity to take further action. But there was no explicit mention of fresh measures under consideration, spurring a kneejerk negative reaction in the markets.

Further, gross domestic product in 2016 estimate was revised up to 1.7 percent, compared to 1.6 percent previously, while 2017 forecasts are cut by -0.1 percent to 1.6 percent. On inflation, 2016 estimate at 0.2 percent was maintained, 2017 cut by -0.1 percent to 1.2 percent and kept 2018’s at 1.6 percent.

Moreover, inflation remains way below the central bank’s 2 percent target. Jan-Aug 2016 inflation averaged 0.03 percent y/y, flat from 2015, mainly weighed by energy prices. Core inflation is relatively firm but struggling to break higher due to excess capacity and limited wage pressures, DBS reported.

"Notwithstanding limited options here on, we expect the ECB to keep the door for further policy action, possibly in 4Q16, contingent on renewed downside risks to growth and/or the risk of negative inflation," DBS commented in its report.

Meanwhile, the next step(s) could be a combination of QE timeline extension beyond Mar17, ease restrictions surrounding these purchases, expand assets’ categories or consider further negative rates. Besides the timeline extension, any decision on altering the eligibility criteria is unlikely to come easy.