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The latest estimate for core inflation in the Eurozone has fallen to 0.8%. Portugal and Spain have slipped into deflation whilst Ireland and Italy are on the brink. Since mid 2012, the last time euro break-up fears flared up, the euro has strengthened by 15% against the dollar and by 50% against the yen. This strength has been decreasing the price of imported goods, including energy. In the last 10 years, around half of the Eurozone’s 2% average inflation has been made up of energy prices, so we believe the recent fall is in line with the low points of previous cycles.

The European Central Bank (ECB) argues that as the economies recover, so should inflation. The problem is that the ECB sets policy based on the aggregate (i.e. 0.8% currently) even though countries with high unemployment and very weak core inflation, such as Spain and Portugal, could do with weaker real interest rates than countries such as Germany, which has 1.2% core inflation.We expect low inflation to remain a problem for some countries, possibly for the rest of the year, but for the region as a whole it will begin to normalise as the pace of deleveraging slows and the currency starts to weaken.

It is also worth noting that some members of the ECB are ‘talking down’ the euro with references to the possibility of quantitative easing and negative real interest rates. This rhetoric is unlikely to have as strong a policy impact as its previous ‘we will do whatever it takes’ promise, but nevertheless it could help ease some of the upward pressure on the euro and, in turn, inflation.