Eurozone consumer price inflation rose 0.9% year on year in January. This marks a significant change from the year-on-year decreases of the past few months, and could herald the beginning of a sustained rise in inflation. Several one-offs and base effects contributed to the rise, but these do not explain the whole of the increase, which was much larger than expected. NN Investment Partners (NN IP) foresees volatility in the inflation rate over the coming months as one-offs continue to have an effect. A sustained rise in inflation could also be on the horizon, bolstered by monetary and fiscal policy action.
Following an extended decline in Eurozone inflation over the past year, with headline consumer price inflation dropping to -0.3% in the closing months of 2020, inflation surged to 0.9% in January. The increase was not entirely unexpected, as several one-off factors were expected to prompt a rise in inflation. These included the end of a VAT cut and the introduction of a CO2 fuel tax in Germany; a shift in the French sales season that translated into positive base effects; and a reweighting of the index that squeezed the basket weight of items that tend to fall aggressively in January.
“The jump in headline CPI represents a remarkable move from deflation to inflation that we cannot attribute solely to one-offs and base effects. Inflation increased by much more than expected, implying that the known one-off factors weren’t the sole contributors. It’s possible that higher shipping costs and supply chain disruptions also played a role.”
Jaco Rouw, Senior Portfolio Manager Fixed Income at NN Investment Partners
The one-off effects are likely to cause significant volatility in the Eurozone inflation rate over the coming months. Headline inflation might initially continue to rise, and could even reach 2% later this year, partly on the back of one-off contributing factors and base effects. Next year inflation will probably decline to around 1% when most base effects drop out of the year-on-year number. Still, NN IP identifies other factors at play that might spur a longer-term rise in inflation levels, such as accommodative monetary policy and the Eurozone’s massive and coordinated fiscal policy response to the coronavirus.
“The higher-than-expected January number dovetails with the ongoing story of a more structural increase in inflation, a topic we discussed last November. Financial markets also seem to be partly pricing in this sustained rise, as 10-year euro-denominated break-even inflation has increased to above pre-Covid levels.”
Jaco Rouw, Senior Portfolio Manager Fixed Income at NN Investment Partners
If inflation exceeds expectations over a sustained period, this would have positive implications for inflation-linked government bonds, as the coupon and principal repayment are linked to the Eurozone inflation index. In contrast, nominal government bonds would be likely to underperform.
“‘Linkers’ would perform particularly well if the ECB were to keep policy rates unchanged at low levels, which seems like the likeliest possibility. This would probably limit the rise in real yields.”
Jaco Rouw, Senior Portfolio Manager Fixed Income at NN Investment Partners
