With clouds over the growth outlook clearing a little, unit labour costs rising and firms' margins being squeezed, we still see strong arguments for core inflation to reach rates of 1.3-1.4% by year-end. However, we emphasise that it will be a gradual uptrend, as the current economic environment remains fragile.
Markets generally remain very sceptical about any core inflation uptick in the current economic environment, in line with the very subdued ECB pricing. In our view, current inflation market pricing remains too low and we see scope for repricing in inflation-related products, especially in H2 19.
We doubt that the projected gradual rise in core inflation is enough to convince the ECB to bring rate hikes back to the table for 2020. First of all, the ECB looks at the medium term - where we project core inflation pressures to peak at 1.5% and abate somewhat - and secondly, the unofficial ECB reaction function has changed in recent years, incorporating inflation as well as GDP growth, bank profitability and financial market awareness. Therefore, we believe that before the ECB will resume its policy normalisation (including a first rate hike), we need to see a pick-up in realised underlying inflation as well as medium-term inflation expectations.
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