Euro area inflation surprises on the upside – will

core inflation follow the upward trend?Pernille Bomholdt HennebergSenior Analyst+45 45 13 20 21/+44 20 7410 8157perni@danskebank.com

31 January 2017

Investment Research

www.danskemarketsequities.com Important disclosures and certifications are contained from page 16 of this report.

11

Euro area inflation increased to 1.8% y/y in January, which is the highest rate since February

2013 and above consensus at 1.5% y/y. The rise in inflation was driven mainly by energy andfood price inflation, which together had a contribution of 1.1pp up from 0.5pp in December.

Core inflation was unchanged at 0.9% y/y in January and has therefore not been above 1.0%

since October 2015. The unchanged core inflation reflected a 0.1pp decline in service priceinflation, whereas non-energy industrial goods price inflation was up by 0.2pp.

Higher inflation was seen across countries – Spanish inflation was 3.0% and significantly

above the ECB’s 2% target – hence, the ECB can conclude that it is not only German inflation

that is higher. That said, it still remains to be seen whether the rise in inflation will affect themedium-term horizon and whether it is a durable, self-sustained convergence.

We expect core inflation to stay low at 0.9% on average this year, primarily as labour market

slack in the periphery countries should keep wage growth subdued. Core inflation will, in ourview, be supported by an indirect impact of the higher oil price but this should not be enough tobring core inflation persistently above 1.0%, as there is less tailwind from a euro depreciation(see more about the main drivers of core inflation below).

The bottom line is that we do not expect the higher inflation figures to change the ECB’s

monetary policy stance, as the underlying price pressure is still weak. Although some ECBmembers have started to express a more hawkish stance recently, consensus in the ECBseems to be that core inflation also needs to rise before the ECB will discuss tapering. We stillbelieve the ECB will announce a third QE extension this year.

Euro area inflation surprises on the upside – will core inflation

follow the upward trend?

22

Higher inflation across euro area countries Inflation set to continue higher in Feb, then lower

Euro area inflation surprised on the upside in January

Source: Eurostat, Danske Bank MarketsSource: Eurostat, Danske Bank Markets

Note the Italian figure is from December – the January figure will be released on Friday.

33

Energy prices following the oil price increase Unprocessed food price inflation rose in Jan

Food and energy price inflation main drivers of higher inflation

Source: Eurostat, Danske Bank MarketsSource: Bloomberg, Eurostat, Danske Bank Markets

44

Drivers of core inflation: Core inflation set to stay low during 2017

Core inflation set to stay low during 2017

Source: ECB, Eurostat, Danske Bank Markets

2. Labour market development affects wage growth

4. Exchange rate development

1. Output gap changes affect profit margins

3. Indirect effect of commodity prices

5. Inflation expectations

55

Core inflation could rise as output gap closes But periphery output gap also needs to close

#1: The closing output gap points to higher core inflation

Source: ECB, European Commission, Eurostat, IMF, OECD, Danske Bank Markets Source: European Commission, Eurostat, Danske Bank Markets

Note the country figures are from December

66

Low service price inflation as wages stay low Philips curve: ECB’s wage forecast is hopeful

#2.1: Low core inflation as long as wage growth stays low

Source: ECB, European Commission, Eurostat, Danske Bank MarketsSource: ECB, Eurostat, Danske Bank Markets

ECB 2016Wages: 1.2%Unemp: 10.0%

ECB 2019Wages: 2.4%Unemp: 8.7%

ECB 2017Wages: 1.7%Unemp: 9.5%

ECB 2018Wages: 2.1%Unemp: 9.1%

77

Large unemployment gap in the periphery Low service price inflation due to slack

#2.2: Periphery labour market slack will keep euro wages low

Source: European Commssion, Eurostat, Danske Bank Markets Source: Eurostat, Danske Bank Markets

Note the service price inflation figures are from September in line with the long-term unemployment figure

y = -0.12x + 1.68

0

0.25

0.5

0.75

1

1.25

1.5

1.75

2

2.25

2.5

2.75

-2 -1 0 1 2 3 4 5 6 7 8

Ser

vice

pri

ce in

flati

on

% y

/y

Long-term unemployment rate (change since 2008)

Long-term unemployment rate and service price inflation

DE

AT

BEFI

IE

PT

FREA

NL

IT

SP

German service priceinflation remains lowand is not lifting theeuro area aggregate

88

Core inflation from 0.6% to 1.1% in 2015 The euro weakening lifted core inflation

#3: Past euro weakening supported core inflation

Source: Eurostat, Danske Bank Markets Source: ECB, Eurostat, Danske Bank Markets

99

The oil price signals higher NEIG inflation… … and also higher service price inflation

#4.1: Indirect, lagged impact of the oil price on core inflation

Source: Bloomberg, Eurostat, Danske Bank Markets Source: Bloomberg, Eurostat, Danske Bank Markets

1010

Higher NEIG as oil impact kicks in in end-17 Transport to lift service price inflation a bit

#4.2: Oil-sensitive components play a modest role for core inflation

Source: Eurostat, Danske Bank Markets Source: Eurostat, Danske Bank Markets

1111

Expected and actual inflation not correlated Service PMI, output prices are not helping

#5: Rising selling price expectations – but a very poor indicator

Source: European Commission, Eurostat, Danske Bank Markets Source: Eurostat, Markit PMI, Danske Bank Markets

1212

Service price inflation set to remain low Core inflation set to rise less than ECB expects

Bottom line: subdued core inflation – ECB is overly optimistic

Source: Eurostat, Danske Bank Markets Source: ECB, Eurostat, Danske Bank Markets

Note the country figures are from December

1313

Mario Draghi’s definition of the ECB’s objective: Higher inflation, but ‘not really’ close to 2%

QE extended again as ECB will not see higher underlying prices

‘We define our objective first of all in the

medium term, over a medium-term horizon.

That's the relevant policy horizon.

Second, it has to be a durable convergence,

so it cannot be transient.

Third, it has to be self-sustained. In other

words, it has to stay there even when the

extraordinary monetary policy support that

we are providing today will not be there.

Fourth, it has to be defined for the whole ofthe eurozone.’

Source: ECB, Eurostat, Danske Bank Markets

1414

5Y5Y inflation exp. not back around 2% level The entire inflation curve is affected by spot

The market is no longer pricing in deflation, but 5Y5Y not yet 2%

Source: Bloomberg, Eurostat, Danske Bank Markets Source: Bloomberg, Danske Bank Markets

-1.00

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

0y 5y 10y 15y 20y 25y 30y 35y 40y 45y 50y

%

Current Average since 2014 Max/min since 2014

1.251.29

1.79

2.18

1.25

1.56

2.232.39

0.280.62

1.24

1.60

0.00

0.50

1.00

1.50

2.00

2.50

3.00

1y 1y 2y 2y 5y 5y 10y 10y

1515

Inflation is priced down at 1.3% in 2019 1Y1Y inflation much higher since summer

The market is pricing in lower inflation again in early 2018

Source: Bloomberg, ECB, Eurostat, Danske Bank Markets Source: Bloomberg, Danske Bank Markets

-1.00%

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 Dec-19

HICP inflation Market pricing

ECB inflation forecast (December) Danske inflation forecast

The market is pricing inflation at only 1.3% onaverage in 2019 vs. ECB's projection of 1.7%

1616

This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske Bank’). The author of the research report is Pernille

Bomholdt Henneberg, Senior Analyst.

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