ECB May Tighten Monetary Policy

Inflation in the Eurozone fell in June, dampening market expectations of tighter monetary policy from the European Central Bank. Early estimates of inflation from the European Commission showed consumer prices rose by only 1.3% in June, down from 1.4% in May.

The euro fell by 0.27% against the US dollar in Friday trading to reach $1.14, retracing some of the gains of the last week. It started the week below $1.12, news outlets reported.

The fall in inflation was driven by the waning influence of energy price increases (of which oil is a major component).

Core inflation, which strips out the effects of volatile energy, food and drink prices, rose to 1.1%. While this was an increase from the 0.9% recorded in the previous month, it was still well below the 2% ECB target.

ECB president Mario Draghi was one of multiple central bank governors to roil bond and currency markets this week when investors interpreted comments as a sign quantitative easing asset purchases will be gradually wound down, or tapered.

The €60 billion ($68.5 billion) bond purchases are set to continue until the end of the year, with no decision yet taken on the future of the program. The ECB's rate-setters meet on July 20, when an announcement could be made, although some economists expect the move to be put off until the September meeting.

Draghi this week said “reflationary” forces had replaced deflation, raising hopes the ECB would act to tighten monetary policy to stop inflation accelerating.

Since the start of the week the German 10-year Bund yield, the risk-free rate for Europe, has risen from lows of 0.23% to highs of 0.473 in trading Friday, before retreating to 0.442%.

However, Draghi and other ECB bankers said markets had overreacted, prompting an abrupt retreat in the euro. Friday’s figures provide further reason for the doves on the ECB’s rate-setting governing council to continue with supportive monetary policy. The ECB, Draghi among them, has consistently said inflation must rise sustainably towards its 2% target.

The third consecutive fall in inflation in a row means ECB taper talk may be overdone, according to Bert Colijn, a senior economist at ING Wholesale Banking. He said: “The overall trend remains weak on lower oil prices, which means that a normalization of ECB policy does not seem to be around the corner.

German, Spanish Inflation

German and Spanish consumer prices rose more than expected in June, giving the ECB fresh food for thought as eurozone inflation moves closer to its target and markets price in a tightening shift in monetary policy, Reuters reported.

The surprisingly strong inflation figures released on Thursday come only days after Draghi suggested the central bank’s asset-purchase program would become less accommodative going into 2018 after regional growth has gained pace and inflation trends returned following a period of falling prices.

German consumer prices, harmonized to compare with other European countries, rose by 1.5% on the year after an increase of 1.4% in the previous month, the Federal Statistics Office said. On the month, prices rose 0.2%.

In Spain, EU-harmonized consumer prices rose by 1.6% year-on-year in June, flash data from the National Statistics Institute showed. This compared with a Reuters poll of 1.5% and previous reading of 2%.

A breakdown of the German non-harmonized data showed energy costs were unchanged in June while food and services inflation clearly picked up, suggesting that Germany’s economic upswing is slowly pushing up underlying price pressures.

“The domestic economy is buzzing. It is quite possible that this will soon be reflected in rising wages and salaries,” KfW Bank economist Joerg Zeuner said. “This is likely to boost the economy and inflation. It would open up new opportunities for the ECB to normalize its monetary policy,” Zeuner added.

With its €2.3 trillion asset buys running until the end of the year, the ECB will have to decide in the third quarter whether to extend or wind down the purchases, reconciling an apparent contradiction between healthy growth and still modest inflation.