The Euro Could be Pressured, Fanciful ECB Projections on Inflation Cited

The Euro exchange rate complex could remain flat for an extended period of time due to chronically subdued inflation, according to a recent report by Danske bank.

Low inflation keeps interest rates low and this results in a weaker currency due to international investors preferring ‘higher interest’ currencies to park their money in where they can earn higher returns. 

Danske say the European Central Bank (ECB) have been over-optimistic in their most recent inflation forecasts, especially core inflation forecasts for 2018 and 2019.

The upgrade by the ECB announced at their recent March meeting was overly hopeful, according to a report by Danske Bank’s Senior Macro Strategist Pernille Bomholdt Henneberg.

“In our view, the ECB’s core inflation forecast is still very optimistic,” said Henneberg.

The Danske analyst cites a number of reasons why he thinks the forecasts are too high.

However, the main reason is that the ECB’s core inflation forecast hinges on increases in wages which are unlikely to occur due mainly to continued high unemployment – or high labour market ‘slack’ as it is called by economists.

Higher unemployment keeps wages subdued because employers can find cheaper replacements if workers demand a raise.

Rise in Headline due to Rise in Core

The ECB’s improved forecasts are predicated on an increase in the contribution to headline inflation from core inflation which excludes volatile food and petrol components.

At the same time the share attributable to those rising fuel and food costs is expected to decline.

Danske’s Henneberg, however, argues this is unlikely to happen because of stagnant wages.

Jobless Still Too High

The Unemployment Rate above which inflation would be expected to stop rising (NAIRU) is estimated at 8.9% in the Eurozone, yet we are still above this and likely to remain so for some time, begging the question of where the extra inflationary pressures the ECB is forecasting will come from?

Danske’s Hennenberg suggests the NAIRU will be achieved in 2018 at which point wages will be rising at 2.1%.

Regardless of the level of employment, however, other factors are further reducing wage growth, possibly linked to low productivity, as even in countries such as Germany wages remain stubbornly low despite high levels of employment.

Mean Reversion

The historical average for core inflation is 1.4% and whilst this is currently above the core inflation rate now (0.9%), it will be below the rate ECB’s forecast rate in 2018 and 2019 of 1.5% and 1.7% respectively.

Danske argues that the model does not take into account the effect of pressure pushing inflation back down to the 1.4% average once it is surpassed.

The mean reversion could dampen the pace core inflation as it rises making gains more difficult, especially at the upper end of the spectrum.