Raising our 2021 inflation expectations for the euro area

Raising our 2021 inflation expectations for the euro area

Bottlenecks and commodity prices are driving up inflation. But we remain to be convinced that price hikes in the euro area will prove sustainable.

Price pressures are building across advanced economies and the euro area is no exception. Several drivers are pushing inflation up. These include the recovery in prices depressed by the pandemic, supply bottlenecks and higher commodity prices. The reversal of VAT cuts and higher carbon prices in Germany as well as changes in weightings in Eurostat’s price indexes may also be factors.

We have revised up our euro area headline inflation forecasts to reflect the stronger commodity prices and supply bottlenecks. We now see headline inflation averaging 1.7% in 2021 (up from our previous forecast of 1.4%). As base effects fade, we expect headline inflation to fall back to 1.3% on average in 2022.

We expect core inflation in the euro area to be extremely erratic this year due to a myriad of technical factors, but we have marginally raised our core inflation forecast to 1.0% in 2021 (from 0.9% previously) and 2022. Mainly because of supply-chain issues, risks to inflation in the coming quarters remain tilted to the upside.

We expect the inflation to spike in H2 2021, when headline inflation rising above 2.0% y-o-y. But while there are some upside risks, we believe this hike in prices should remain transitory.  To change our view, we would need to see signs of increasing tightness in the labour market. Signs of increasing tightness in labour markets could determine whether the temporary rise in prices turns into something more permanent. So far, wage growth has remained subdued in the euro area.

The ECB will look though strong headline prints in the coming months. Nevertheless, the battle between the bank’s hawks and doves is bound to intensify as economic fundamentals improve. Whether the ECB maintains the “significantly higher pace” of PEPP purchases it committed to last March when it meets on 10 June or instead reduces the pace of purchases is a close call.

Ultimately, the ECB’s broader policy stance is the more important issue. Given the subdued medium-term inflation outlook for the euro area, we expect highly accommodative monetary policies to continue.

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