Euro area inflation: normalisation to continue, even with upside risks in second-half 2024

Euro area inflation is heading back to 2%, in line with our view of normalisation. Market-implied year-on-year forecasts for inflation in September this year are also centered around 2%, but include upside risks. We see inflation below 2% due to base effects before reaccelerating, but do not subscribe to a second-wave narrative.

• En route to normalisation, we expect euro area inflation to temporarily fall below 2% early in the second half of 2024, followed by a re-acceleration driven by base effects and persistence in services inflation.
• Our analysis of market-implied probabilities endorses this view, but also highlights the high uncertainty around inflation and the market's perception of upside risk.
• We expect the ECB to start to gradually reduce interest rates despite inflation likely trending upwards later in the year, but to still keep rates in overall restrictive territory.
• In the context of normalisation to 2.1%, a temporary and marginal re-acceleration in inflation would have minor effects on insurance claims, in our view.

In February 2024, euro area inflation was 2.6% year-on-year, down from slightly above 5% last summer. This is meaningful progress, and we expect disinflation to continue. We see consumer price inflation likely to temporarily fall below 2% in the early second-half of this year on the back of strong base effects from lower energy prices.¹ However, we project some reacceleration in inflation in the second half, as energy base effects fade and as services inflation is to remain sticky on still elevated wage growth (see Figure 1). The shipping disruptions also add upside risks to European inflation if these continue into the second half of this year – the peak shipping season.² However, a broad-based second wave of inflation is not our baseline view.

Figure 1: Base effects on euro area inflation of different inflation components

Following European Central Bank (ECB) President Christine Lagarde's recent comment "we will know a lot more in June",³ we see the ECB's June meeting as the most likely when the central bank will to start to cut interest rates. This is noteworthy, as rate cuts would come not much before when we expect inflation to bottom and then drift higher. The optics of the rate cuts will look deceiving, and a bottoming in inflation combined with an anticipated reacceleration in GDP growth could lead to second wave of inflation worries. We warn against this narrative but highlight that, given a temporary reacceleration, the ECB will likely proceed cautiously with rate cuts. In our view, a temporary inflation reacceleration driven mostly by base effects does not constitute a second wave. Our baseline view still is that inflation is normalising over the medium term. We see a temporary and negligible re-acceleration primarily driven through base effects as having only a marginal effect on insurance claims in lines of business that are inflation sensitive.

We complement our analysis of this year's inflation trajectory by deriving a probability distribution for euro area inflation from options markets. Following methodology from the Minneapolis Federal Reserve and also Kitsul and Wright,⁴ we look at the variation in option prices maturing in December 2024 at different strike rates and derive a probability density function for euro area inflation (see Figure 2). This approach allows us to assess the expected value, uncertainty and skewness of euro area inflation as seen by market participants. Though not unique to us, it is the first time this analysis, in the European context, is show-cased in the public arena.

Figure 2: Euro area y-o-y inflation expectations

Consistent with our view, the distribution is centered around the 2% ECB target, with a mean value of 2.1% in the longer-run. This suggests that inflation expectations are anchored. That said, the option-implied uncertainty is historically elevated and, for instance, is almost twice as high compared to January 2020. Finally, and most importantly, the option-implied distribution displays a positive skew: a long tail to the right side, towards higher levels of inflation. This corroborates our view that starting in the second half of 2024, inflation will increase again on the back of declining energy base effects. Further, the long right-side tail highlights that markets are currently more concerned with upside rather than downside risks to inflation. This likely reflects uncertainties over whether wage growth in Europe has reached an inflection point.  It also likely reflects concerns of disruptions to supply chains on account of the Red Sea and geopolitical conflicts (the Middle East, Ukraine/Russia).

All told, the overall direction of travel for euro area inflation is, in our view, to normalize towards 2.1% in this decade. This transition, however, from the high inflation period of 2022-23 will not be smooth, but rather bumpy. We see inflation temporarily falling below 2% early in the second half of this year, with some increase again afterwards. Our analysis of market-implied probabilities endorses such a view but also signals the high inflation uncertainty and market perception that risks have shifted to the upside.