Euro Retreats after Inflation Disappointment, Italian Budget Dilemma Cast Doubt over ECB Policy Outlook

Commerzbank HQ dominates the Frakfurt skyline. Image © Andre Douque, reproduced under CC licensing conditions

- EUR weakens after Italian budget, September inflation disappointment.

- CPI rises to 2.1% in September but core-CPI falls to 5-month low of 0.9%.

- Italian politics, inflation, place question mark over ECB policy outlook.

The Euro weakened in the final session of the week as traders responded to negative developments in the Italian budget process and a surprise fall in the rate of core-inflation for the Eurozone that have placed a question mark over the European Central Bank (ECB) monetary policy outlook. 

Eurozone inflation rose by 2.1% during September according to Eurostat, up from 2%, which reverses the 10 basis point decline seen back in August. 

Core inflation, which removes volatile commodity items from the goods basket and so is thought to provide a better reflection of domestically generated price pressures, posted a surprise 20 basis point fall to a five-month low of just 0.9%

"The 2% headline inflation remains pretty much an oil story," says Peter Van Houte, chief Eurozone economist at ING Group. "However, the European Central Bank looks through these temporary effects and pays more attention to the underlying price dynamics."

Currency markets care about the inflation data because consumer price pressure have a direct bearing on the interest rate and other monetary policy decisions of the European Central Bank, and it is changes in rates themselves that are the raison d'être for most moves in exchange rates.

Changes in interest rates, or hints of them being in the cards, are only made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

"Bear in mind that we might see signs of a significant slowdown in the US towards the end of 2019. And then the question is: can the ECB embark on a tightening cycle when major trading partners are facing a serious slowdown and inflation still isn't going anywhere," warns Houte. 

The Euro-to-Dollar rate was quoted 0.31% lower at 1.1599 following the release, after falling from 1.1630 previously, while the Euro-to-Pound rate extended losses to trade 0.20% lower at 0.8821 making for a Pound-to-Euro rate of 1.1257.

Europe's single currency was firmly on the back foot Friday as a result of the latest developments in the Italian budget process.  

"Energy prices have been dominating EZ inflation and that looks set to continue this month," says Elsa Lignos, global head of FX strategy at RBC Capital Markets. "The impact of oil prices is most clearly illustrated by the differing trends in headline and core inflation this year. Over the past four months (May to August) headline inflation has averaged 2% y/y compared to 1.3% y/y in the four months between January and April. Core inflation on the other hand has remained broadly flat averaging 1.0% y/y in both periods."

Europe's consumer price outlook has improved in recent months and core inflation is now set to reach 1.8% by the end of 2020, or so goes the story told by Mario Draghi in testimony to the European parliament last week.

"Annual rates of HICP inflation are likely to hover around current levels in the coming months and are projected to reach 1.7% in each year between now and 2020. This stable profile conceals a slowing contribution from the non-core components of the general index, and a relatively vigorous pick-up in underlying inflation," the European Central Bank (ECB) chief told a parliamentary committee.

This would leave the rate of core inflation at the ECB's target of "close to but below 2%" and vindicate the central bank for its decision to cut the amount of government bonds it buys each month to €15 billion at the end of September, before reducing its purchases to zero in December. Interest rates are still to "remain at their present levels at least through the summer of 2019".

However, some economists have warned not to place much emphasis on Draghi's comments as they are based on ECB forecasts that could eventually be shown to have been too optimistic. Friday's data could be taken as evidence of the perils faced by those who take the ECB chief's pronouncements to heart.

The European Central Bank has been fighting against below-target inflation and weakening price pressures ever since the middle of 2012, around the time the Eurozone debt crisis began to dissipate. 

However, Eurozone CPI fell from 2.7% in September 2012 to a low of -0.6% in January 2015. It has since risen back to 2% on a number of occasions, notably in March and April 2017, only to go once again into retreat immediately after. Core inflation, the truer measure of domestic price pressures, has never made it above 1.2% in all that time.

With inflation and interest rates both now rising elsewhere in the world, the ECB may be keen to begin normalising its monetary policy so as not to get left behind. It may even be able to claim victory in its fight against low inflation at some time over coming years.

However, a looming confrontation between Italy and the EU threatens to deprive the Euro of any benefit, due largely because of the former's budget policies. 

"Arguments of monetary policy speak for a late start of the hiking cycle and for a slow pace. Nonetheless the hope of it arriving is the reason for why the euro is generally quite strong," says Ulrich Leuchtmann, head of FX strategy at Commerzbank. "If in addition to monetary policy arguments, the ECB now had to prevent excessive BTP yields (to prevent Italy from sliding into the next fiscal crisis) that would limit the ECB’s interest rate policy scope further. In that case the most important reason for why the euro trades at 1.1650 (against USD) rather than at 1.05 or so would at least be weakened."

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