C. Europe Inflation Springs Back

Inflation in Central Europe rebounded in December to multi-year highs, in a turnaround likely to continue this year on rising oil prices, a jump in wages and loose fiscal policies.

Central banks in the eastern wing of the EU have been easing monetary policy since 2012 amid anemic inflation. But they are unlikely to raise interest rates due to the changing inflation picture just yet, as price growth does not exceed their targets, Reuters reported.

Among them, the National Bank of Hungary could be the most dovish, potentially making Hungarian bonds the most exposed to “reflation trade” in the region, some analysts said.

Hungarian annual inflation accelerated to 1.8% in December—its highest level since July 2013 and above analysts’ consensus forecast for 1.6%, data showed on Friday.

In the Czech Republic, annual inflation hit its highest rate in four years in December at 2%, while Poland saw prices climb 0.8% in the year through December, up from no change in November based on preliminary data.

Romanian annual inflation was still negative in December, however.

“In the short term, inflation is fueled by oil prices and a jump in food prices, but we can also see that there are more and more factors that will also raise core inflation,” said Eszter Gargyan, an economist at Citibank.

She cited loose fiscal policies, rising wages across the region, a shortage of labor and higher energy prices feeding through into services prices. “The market has started to price this in, as we could see Hungarian (bond) yields rising significantly in recent days,” she added.

The yield on three-year Hungarian government bonds has risen about 15 basis points and the 10-year yield has climbed about 20 basis points since the start of the year. Hungary’s central bank has pushed down short-term yields with its policies, so the yield curve could steepen as inflation picks up.

Years of emigration to Western Europe have created labor shortages across Central Europe, leading governments to hike wages sharply as unemployment rates dropped.

Analysts say this all poses an upward risk to inflation, which is hard to estimate. “The market is getting somewhat distracted by oil price moves and base effect CPI inflation narratives when the real and more substantive risk to Central and Eastern Europe inflation is labor markets,” Nomura said in a note.

Trump's Policy Risks

Europe's economy is recovering "at a moderate but firming pace" but headline inflation will rise "significantly" in the coming months, according to the monetary policymakers at the European Central Bank.

The ECB also said Brexit uncertainty and the election of Donald Trump presented risks to the EU economy, while "political uncertainty remained high".

In minutes from the interest rate-setting Governing Council's last monetary policy meeting, the ECB said "strong upward base effects in the annual rate of change of energy prices" would help to push up prices.

US president-elect Trump's fiscal policies were also seen as a possible source of "upward impact" on prices in the Eurozone.

However, the ECB's chief economist, Peter Praet, said underlying inflation (excluding volatile energy prices) lacked "a convincing upward trend"–meaning the ECB had "revised down" the core inflation outlook.

The minutes recorded discussions from the ECB's last monetary policy meeting, which took place on December 8 last year. At the meeting the bank extended its quantitative easing program but reduced its scale from €80 billion ($85.15 billion) per month to €60 billion per month.

ECB president Mario Draghi was keen after the meeting to emphasize the bank's continued commitment to accommodative monetary policy. The minutes record Praet raising the possibility of raising quantitative easing purchases back to €80 billion per month "if the outlook became less favorable, or if financial conditions became inconsistent with further progress towards a sustained adjustment of the inflation path."

The next monetary policy meeting in Frankfurt will take place on January 19, with little expectation of a change in interest rates or a modification to the quantitative easing regime.