The macro in EUR inflation and equity markets

We emphasised that while a broad-based European recovery continues, the acceleration in Euro area activity is behind us. A rotation of growth from fading net trade contributions to stronger domestic demand is under way, yet this rotation has disappointed in parts of the Euro area . We continue to expect sequential growth rates at slightly above the rate of growth of potential output, which we estimate at close to 1½% p.a. Our views of “stubbornly weak” core inflation and its implications for ECB policy also remain intact.

Above-trend growth reassures the ECB that core inflation will move slowly back towards its target. We expect that convergence of inflation to target to happen more slowly than do ECB staff. But, on either view, convergence will be gradual. The key driver of the short-term monetary policy outlook, therefore, is whether GDP growth remains above-trend. On this basis, we expect a first rate rise in 2019 Q4 and specifically in October. Downside risks to our outlook imply risks to a later rate rise.

What drives Europe’s outlook in the eyes of financial markets? We identify the macro factors perceived by financial markets by exploiting the joint movement in four EUR asset prices. The focus in this exercise is more short-term than in our macro forecasts, where we look to medium-term developments. Here, we focus on the estimated impact of macro factors on EUR inflation and on equity prices.

 EUR inflation has fallen by 5bp since early-August. At 1.69%,  inflation is significantly below — in fact, around 30bp lower than — its level when Mr. Draghi spoke at Jackson Hole in August 2014 drawing attention to the weakness of EUR inflation. On that occasion, Mr. Draghi highlighted that such developments had raised real interest rates, encouraging the Governing Council to use all available instruments to ensure price stability over the medium term. This presaged the ECB announcing its expanded asset purchase programme including public sector asset purchases.

More recently, the ECB has expressed confidence that a recovery under way will ultimately return inflation to levels consistent with the ECB’s definition of price stability in the medium term. We agree with this view. Our own view is that above-trend growth plays a key role in reassuring the ECB that core inflation will move slowly back towards its target.

We expect the convergence of inflation to target to happen more slowly than do ECB staff. But, on either view , convergence will be gradual. The key driver of the short-term monetary policy outlook is whether GDP growth remains above-trend, rather than the level of headline inflation.

A recent soft patch in equity markets. Equity prices have fallen by 5% since early-August and have been range-bound over longer horizons. We saw the recent equity market softening from early August as driven by weaker foreign demand news  as well as the unwinding of dovish monetary policy news at the June ECB