Medium-term outlook for Euro area inflation depends on growth

The ECB's January decision to add sovereign debt to its asset-purchase programme was likely the last step in the easing cycle that began in June 2014. Since then, the ECB has lowered the refinancing rate to 0.05% from 0.25%, lowered the deposit rate to -0.2% from 0.0%, launched its Targeted Long-term Refinancing Operations (TLTROs) and launched a EUR 1.1tn asset-purchase programme. These measures are likely to have had some impact on inflation already, which will likely increase over the medium term.

Even if headline CPI inflation reaches its target at some point in the next 12 months due to a sharp oil-price rise, the ECB will treat this as a transitory effect. Focus will be on core CPI, wage growth and unemployment, as is the case currently in the US and the UK. In the medium term, inflation's return to a sustainable near-target rate will largely depend on whether euro-area spare capacity shrinks significantly. 

"The euro-area output gap in 2014 was around -3.0% and the European Commission expects this to shrink to 1.2% by end-2016. In comparison, the Bank of England estimates the UK output gap to be around -0.5%, and there are still no signs of strong inflationary pressures", notes Standard Chartered.

Ongoing inflation-rate is seemed to be divergence across countries. Germany and some other strong 'core' countries such as the Netherlands and Austria are likely to experience persistently above-target inflation if euro-area CPI is to meet its overall target, says Standard Chartered. This is because spare capacity is unevenly spread throughout the euro area: the German output gap is likely to close by 2016, but it will likely take longer to reduce spare capacity in the weaker countries. Higher inflation differentials for a sustained period would be positive, as they would help to correct competiveness imbalances across the euro area faster than the process of internal devaluation.