German inflation in August signals new headache for ECB

Based on the results of six regional states, German headline inflation remained unchanged at 0.2% YoY in August. On the month, German price development was flat. Based on the harmonised European definition (HICP), and more relevant for ECB policy making, headline inflation remained unchanged and stands now at 0.1% YoY. A quick look at the available components at the regional levels shows that low headline inflation is not only the result of lower energy prices but also some tentative second-round effects on consumer goods. At the same time, higher prices in the service sector indicate that there is clearly no risk of deflation for the German economy. Interestingly, the weakening of the euro exchange rate is still not visible in significantly higher import prices. To the contrary, import prices continue to fall, with latest data showing a 0.7% YoY drop in August. Looking ahead, the latest plunge in commodity prices should leave its marks on headline inflation in the coming months. Even a drop into negative territory cannot be excluded. Against this background, reaching the official Bundesbank projection of 0.5% annual inflation for the entire year 2015 has become highly unlikely. It would actually require headline inflation to average 0.9% in the remaining months of the year. In our view, headline inflation should stay close to but above zero for the post-summer months before gradually increasing towards 1% YoY. Consequently, these low inflation rates should continue supporting private consumption. While low inflation or even negative inflation rates are a blessing for German consumers, they could become a new headache for the ECB. As at the end of last year when the discussion about a possible QE started, the ECB is again confronted with deflationary forces. Or to be more precise, with disinflationary forces. With commodity prices now significantly lower than back at the end of 2014, the ECB will have to decide whether low or negative inflation rates are rather positive (ie strengthening purchasing power and domestic demand) or negative (ie contributing to dropping inflation expectations). This discussion should be sharpened by the latest round of ECB staff projections, which in our view should show a significant downward revision of the ECB’s inflation forecasts. The last edition of the ECB projections back in June included the technical assumption of an average oil price of 64 USD/b this year, 71 USD/b next year and 73.1 USD/b in 2017 (based on future contracts). Even if the cut-off date of the latest projection round was probably slightly before the peak of recent market turmoil, these oil price assumptions do now look very outdated. Just doing some quick back-of-the-envelope calculations suggests that the new commodity environment could lead to downward revision of the ECB’s inflation projections of between 0.4 and 0.6 percentage points for 2016 and 2017. In June, the ECB projected inflation at 1.5% in 2016 and 1.8% in 2017. Admittedly, the ECB projections are much more complex and sophisticated than our back-of-the-envelope calculations. However, anything else than a clear downward revision of the ECB’s inflation numbers next week would be a surprise. All in all, the latest plunge in commodity prices will clearly revive the good vs bad deflation debate in the EuroTower. For the time being, this should not yet lead to new policy action. However, recent comments by ECB chief economist Peter Praet confirm our view that latest market developments have rather increased than decreased chances for more QE.