Inflation in the Eurozone? Yes please!

European inflation is cautiously rising, but for the time being the European Central Bank (ECB) is far from going full steam ahead. That will probably keep interest rates low for a long time to come. But how is it possible that the euro rises against the dollar?

The financial world has been under the spell of rising inflation in the United States in recent weeks. This is much less noticeable in the eurozone. Inflation there has risen to 1,7%. That is still lower than the official ECB target, which aims for an inflation rate of just below 2%. In the United States, inflation is 4%.

There are several reasons behind this large gap. The American stimulus measures are relatively more extensive than the European ones. In addition, the lockdown measures in the United States are being rolled back considerably faster. This gives consumers more room to go out and spend money.

Catching up effect
There is a good chance that this catching-up effect will also be seen in Europe later this year. But the chance that this increase is the prelude to a structural inflation revival is smaller than on the other side of the ocean. The European labor market is less flexible than the American one. Moreover, unemployment in the eurozone is also slightly higher.

The danger that rising salaries will start a wage-price spiral is therefore much smaller. In the current year, inflation may increase to 2020% due to the comparison effect with corona year 2. But for the period after that, the bond market is pricing a pullback towards a level of about 1%.

Low inflation: advantages and disadvantages
An important reason for this low expectation is the specter of Japan. Partly as a result of an aging population, that country has been struggling with deflation for decades. There are two sides to low inflation. All the ECB's efforts to fuel inflation have reduced the savings rate to around 2%.

In fact, from 1 July you have to pay at some banks to save if there is more than €100.000 in your account. On the other hand, you pay a very low interest rate on a new mortgage. Its interest rates are linked to bond market yields, which will only rise if inflation expectations rise.

The Remarkable Strength of the Euro
Low interest rates often lead to a weaker currency. But this is hardly noticeable with the euro. Over the past year, the currency has appreciated more than 10% against the dollar. It has everything to do with inflation. Both the policy rate and the interest rate on bond markets are higher in the United States than in Europe.

But real interest rates – taking into account much higher US inflation – are actually much lower. As long as inflation in the United States is significantly higher than in Europe and the Federal Reserve does not rush to intervene, a relatively strong euro could put a brake on the European export sector. That will only come to an end if the ECB succeeds in boosting inflation expectations for the long term: inflation? Yes please!  

Joost Derks

Joost Derks is a currency specialist at iBanFirst. He has over twenty years of experience in the currency world. This column reflects his personal opinion and is not intended as professional (investment) advice.

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