EZ HICP Review: Headline Surges as Core Slips Back?
The first of the Iran War induced rise in prices has arrived but with the flash March HICP data a little below expectations, both the consensus and that of the ECB. Instead, the headline rate spiked higher to 2.5% from February’s 1.9%, but with the core rate falling back (Figure 1) underscoring that this March surge was purely energy-led. Indeed, this March data suggest benign price pressures outside of energy, albeit with spill over effects and more energy price rises yet to come. Even so, with us seeing more real economy and labor market damage which together with tight(er) financial conditions we do not see the HICP rising as much as the ECB envisages beyond this quarter but we do concur that the headline may be back below target by mid-2027. Thus we see the peak in HICP inflation just under 3% around mid-year. We accept risks – but on both sides but note the marked contrast in the labor market and consumer perceptions compared to the inflation surge that followed the invasion of Ukraine four years ago (Figure 2&3)!
Figure 1: Headline Sharply Higher But Core Lower
Source: Eurostat, CE, % chg y/y
Having dropped to 1.7% in the January data, the headline HICP rate rose 0.2 ppt to 1.9% in February only partly due to energy. Even more unexpectedly, the core rose similarly to a 3-mth high of 2.4%. That reflected a fresh rise in services inflation and less weak non-energy goods prices, the former though linked to the Olympics which should have reversed in March data – hence the anticipate drop in the core for this month which did materialise.
Of course, the Middle East conflict is changing what has been a clear disinflationary outlook that seemingly persisted into March outside of energy. Given volatility in energy prices and uncertainty about conflict goals and timing, projecting the EZ outlook at this juncture is fraught with risks greater than usual.
Figure 2: Jobless Rate Picture – Then and Now
Source: Eurostat, ECB (%) 12 quarter development
The more vocal hawks at the ECB remain focused on seemingly still apparent resilient services inflation but now are allowing the energy price surge to perturb them further. Of course, the ECB is still reverberating from the energy-induced surge in inflation that ensued from the pandemic and then the Ukraine War and the criticism levied at it about being slow to react. But perspective is needed as it is important to stress that the EZ economy is better positioned to absorb shocks, with the current situation very different from that of Feb 2022 and the Ukraine War in which in losing access to Russian gas was a ‘shock’ super-imposed on an EZ economy where demand was recovering from the pandemic the latter having caused clear shortages. Indeed, despite the mini recession that soon followed the Feb 2022 invasion, the EZ jobless rate continued to fall, a contrast to the picture the ECB sees in coming years (Figure 2) – which we think is too optimistic.
Admittedly we have and still argue that jobless rate is far from the best indicator of labor market tightness. But there are other factors that should help contain wage related spill over effects not least what so far seems to be a muted response by consumers regarding the inflation outlook; the latest European Commission survey data suggest that the m/m jump in household inflation expectations this month is much less than that seen four years ago despite a much larger rise in the oil price this time around (Figure 3)!
Admittedly, a further rise in inflation is already emerging given what is happening to retail fuel prices so far this month - in some cases seemingly rising much more than perhaps the wholesale price would suggest. But particularly given the labor market and consumer sentiment backdrop, we see only some limited second round effects that will affect overall prices into 2027 (though where actual inflation at the end of next year may be lower than previously thought).
Indeed, and on the baseline of a 4-8 week war, we now see 2026 HICP inflation some 0.5 ppt higher than envisaged three months ago, averaging 2.2% but with a dip back below 2% on the cards by mid-2027 (as does the ECB) and with the HICP outlook on average for next year little changed at 1.9%.
This will be partly on account of the likely real economy damage from the conflict but also reflects our long-standing view that the ECB has been complacent, downplaying what we regard are downside real economy and monetary risks which may now be materialising and possibly more intensely given the manner in which financial conditions have tightened.
Notably, banks have not only been tightening credit standards for some months now but are actually refusing to lend to an increasing amount of companies and are now raising effective rates to customers, this making the next ECB bank lending survey (2 days before the next Council meeting on Apr 30) all the more important. This raises the question about credit availability because the Council may have to contend with a backdrop where the supply of credit (vital to the real economy) may have tightened even before it considers what it should do to the price of credit (Ie interest rates).
Figure 3: Consumer Inflation Worries in Perspective
Source: Bloomberg, European Commission, ECB
All of which makes us underscore that even with some reassessment by markets having occurred of late, the likely real economy and labor market damage of the conflict is still being underplayed.