Euro Area Watch: Inflation – on track so far

• Despite a lot of movement in different sub-aggregates, our inflation for headline and core inflation remains unchanged.
• Food and energy inflation are developing more favourably than expected.
• Goods inflation is also significantly below expectations – the broad based manner of the decrease indicates some persistency.
• Service inflation is somewhat higher than expected – partly due to fundamental reasons, partly due to base effects and price volatility.
• Core inflation is expected to reach 2% by 2025, mainly as a result of weak goods inflation.
• Headline inflation is forecasted to remain below core inflation over the forecast horizon.

Inflation table

Source: Macrobond, RBI/Raiffeisen Research

When we published our euro area inflation forecast in February, we expected inflation to be much tamer than in 2022 and 2023, slowly decreasing over the course of the year, with some erratic behaviour caused by base effects. Furthermore, inflation was expected to be driven by four main factors: base effects in energy prices, deceleration of food inflation, relief of supply chain issues translating to disinflation in goods, and stubborn service inflation. The stubbornness of service inflation was to be the main driver why both headline inflation and core inflation should remain above their 2% target.

The good news is that all of the aforementioned factors have materialized, and as a result our forecast holds up very well even today. Nevertheless, some factors have been stronger than we anticipated, namely those affecting goods and services.

Energy prices no longer dragging inflation down

Energy prices no longer dragging inflation down (contributons to % yoy)

Source: Macrobond, Eurostat, RBI/Raiffeisen Research

Food inflation has decelerated slightly more than we anticipated in our forecast. Inflation momentum and the end of the year indicated that the fastest part of the decreasing trend was already behind us, but in fact it was just catching its second wind. Food inflation from February to May was not only much lower than in 2022 or 2023 but was in fact slower than the long-term average. However, historically food inflation is usually a bit faster than the headline inflation, we thus think that further space for deceleration is limited.

Energy inflation also surprised positively, coming in lower than we expected. The decrease was caused by more favourable wholesale market prices of energy commodities: oil, gas as well as electricity prices have been lower than at the end of 2023, and lower than our original forecast anticipated. However, both natural gas and electricity prices on wholesale markets have somewhat recovered and like with food, there is little space for further decreases.

While food and energy prices are notoriously volatile and difficult to predict, goods prices are supposed to be more stable. In that sense, the surprise of a strong decline in goods inflation is much stronger. While we did expect goods inflation to decelerate strongly from 5.0% in 2023 due to the resolution of supply chain issues, we forecast that it will be hovering around 2%, with a slight acceleration in Q4, as a result of base effects. Instead, goods inflation has cratered and in May 2024 stood at 0.7% yoy, which is closer to pre-Covid levels than the 2% inflation target of the ECB. The decrease is not concentrated in one sub-aggregate, but is broad based and in all three parts of the goods basket (durables, semi-durables and non-durables) has inflation decelerated significantly. We therefore expect that this deceleration is persistent and not caused by a one-off effect.

While the previous parts of inflation have come in lower than expected, the opposite is true in services. In February, we explained that inflation momentum in services was no longer decreasing and that service inflation is proving to be very stubborn in coming down. Since then, inflation momentum has fully turned around and service inflation has basically remained stable in yoy terms from November 2023 onwards, hovering around 4.0% yoy. But while the headline number for services looks worrying, a look under the hood indicates that even in services, the worst could be behind us.

Services and goods inflation have taken different paths (% yoy)

Source: Macrobond, Eurostat, RBI/Raiffeisen Research

There are objective factors keeping service inflation high (increased household income, relatively high wage growth coupled with negative productivity growth, pent-up demand from the pandemic to name a few), but there are also some abnormalities in service inflation data that are hiding a very slow but nevertheless real deceleration of service price growth. Looking at the main drivers of inflation we see insurance costs (which are mostly a lag of higher goods inflation), a base effect caused by German train ticket prices (which have artificially supressed inflation from May 2023 to April 2024 by ca. 0.2pp), earlier Easter, and the typically erratic behaviour of air ticket prices and package holidays. Excluding these factors, service inflation has been slowly decelerating, with the stress on slowly: as we explained even in February, there are fundamental reasons for higher service inflation, which have not gone away, but the fundamental factors in and of themselves should not be enough to keep inflation close to 4%. We thus forecast that even in services, inflation will slowly come down in the second half of the year.

Summing up, while there has been a lot of movement under the hood, and while some fine-tuning may be warranted, we are sticking with our original forecast for the time being, as it is holding up pretty well so far. We expect headline inflation to reach 2.6% yoy on average in 2024, followed by 1.9% and 1.6% in 2025 and 2026 respectively. For core inflation, we expect it to be 2.7% yoy on average in 2024, decelerating to 2.3% yoy in 2025 and further to 2.0% in 2026. Service inflation, and with it inflation as a whole, could thus be tamed by late 2025.