Since the last ECB meeting, inflation has surprised slightly to the downside, printing at 0.5% y/y in March (down 0.2pp from February). The fall in headline inflation was broad-based, with both core and volatile components contributing. Food, alcohol and tobacco (-0.11pp contribution) and services (-0.09pp contribution) were mainly responsible for the headline drop, and to some extent anticipated due to seasonal factors.
ECB President Mario Draghi admitted that there had been an element of “genuine” downside surprise in the March inflation data, and that the GC had opted to wait for more information to assess any medium-term implications. We think this is an implicit reference to food prices, which were particularly weak.
Food has come on the weak side since the beginning of the year and could put further downward pressure on headline inflation in the coming months, particularly in the context of strong negative base effects stemming from adverse weather last year. Meanwhile, energy prices are likely to act as a partial offset, unless the large slide in Brent spot prices recorded in early April is confirmed or extends further.
Overall, we reiterate our view that not having cut rates already, the ECB may be reluctant to do so in the months ahead as economic activity gradually improves, unless April inflation defies expectations of a bounce back close to 1.0% on higher travel and other service prices around the Easter holidays (mainly package holidays and hotels).
Meanwhile, in the months ahead, we expect euro area economic activity to grow at an average pace of 0.3%/0.4% q/q (ie, 1.3% for 2014 as a whole), as suggested by this week’s final PMI composite standing at 53.1 in March. Also, a 0.4% m/m increase in euro area retail sales in February suggests significant upside risks to our baseline private consumption forecast, adding further evidence that economic growth is indeed rebalancing toward domestic demand.
In contrast, we have a below-consensus inflation outlook and continue to see significant risks to the downside. In addition to the aforementioned downside risks stemming from food prices over the next few months, we highlight that the internal devaluation and structural reform process is likely to continue to exert downward pressure. Finally, we also expect weak global inflation factors and a strong euro to persist.
Should inflation continue to surprise to the downside, the ECB made it very clear that the “Governing Council is unanimous in its commitment to using also unconventional instruments within its mandate in order to cope effectively with risks of a too prolonged period of low inflation.” President Draghi particularly mentioned a “very rich” and “ample” discussion on possible further easing measures.