Core inflation is forecast to increase over the coming months, and wage growth is picking up pace in Europe, prodding the ECB to keep a closer eye on monetary policy.

The summer heatwave in Europe could lead to higher inflation since food prices will rise because of crop damage. Core inflation, which strips out changes in energy and food prices, showed surprising weakness in August. The inflation measure fell to 1.0% in August from 1.1% in July. On closer inspection, however, the August data is a bit misleading; it may well have been an artifact of seasonality and the different ways in which national authorities and the European Union make adjustments.

The latest inflation forecast is important. While headline inflation will show the effects of global energy market developments and is beginning to show the effects of the hot summer on food prices, core inflation is forecast to rise later this year and in early 2019. We do not view this as a particularly controversial forecast because it largely reflects base effects and not a sustained rise in inflationary pressure. Still, it is a large increase. Core inflation is expected to increase as eurozone wage growth improves.

Unemployment in the eurozone continues to fall, and in the second quarter of 2018, negotiated pay rose 2.2% year on year, 0.7 points higher than a year ago. National data on compensation for employees showed wages rising about 2.4% in the second quarter from 2.0% in the first quarter. While we don’t have the official eurozone figures, they are likely to be near the average for the national data. It’s possible the rise in core inflation will generate some volatility in the interest-rate markets and could push global rates higher. This is not because it’s a major inflection point in global inflation trends, but because expectations are so low.

The narrative that the eurozone is stuck in a Japanese-style low inflation equilibrium has too many adherents.

The narrative that the eurozone is stuck in a Japanese-style low inflation equilibrium has too many adherents. If the forecast is correct, it will force a lot of people to rethink their positions, pushing rates higher. The ECB is on the lookout for signals that inflation pressures are building as it prepares to end its bond-buying plan later this year. Restless hawks at the ECB will pounce on signs of rising inflation and wages.

Eurozone inflation picks up. Eurozone inflation forecast (% year-on-year)

New auto emissions standards

There is also a major change underway affecting the auto market in the eurozone. Beginning in September, new vehicles will need a new emissions certification. Vehicle sales surged in August as older models were discounted to clear dealers’ showrooms. The new standards will boost estimates of retail sales and capex if the vehicles are purchased by corporations. The data for the summer months is likely to show a fall in auto production and a surge in auto demand. Since this is a large sector, the data will give a misleading picture of the economy. The underlying story is that the eurozone economy is growing at a steady pace, after the volatility of the first half, with decent growth in domestic demand.

Trade conflicts do matter

The ongoing trade conflicts between the United States and its major trading partners will have a negative impact, especially for Germany. Over the past couple of months, business confidence measures in Germany have moved up and down as concerns over tariffs and an escalation in the trade wars waxed and waned. Beyond confidence, we are starting to see evidence of real effects. The latest German factory orders showed an increase in domestic orders and a decline in foreign orders.

Germany, Europe’s biggest economy, is a major global supplier of capital goods. The decline in external orders is an indication that global investment plans are being reconsidered in the light of the tariffs the Trump Administration are pursuing. German industrial production dropped 1.1% month on month in July 2018, missing consensus estimates while reflecting the auto issues and the trade tensions.


More from Macro Report
Download the Macro Report (PDF)

The global economy is expected to enjoy relatively solid growth even as emerging markets tumble and the trade wars escalate.