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Daily Insight

1 March 2016

Inflation report signals ECB should be bold

Eurozone inflation falls and it is not just oil

There is probably a moment in every Governing Council meeting that the doves bring up

how low inflation is and the hawks respond by saying it is all just energy and core inflation is

off its lows (just guessing). Well that conversation is unlikely in March. Headline inflation

dipped back into negative territory in February (-0.2% yoy from +0.3% in January), indeed

partly due to energy. However, core inflation also fell back significantly (+0.7% yoy from

1%). It is now almost back to the lows seen at the turn of last year (of 0.6% yoy).

Import prices push core goods inflation lower

%yoy

Source: ABN AMRO Group Economics, Thomson Reuters Datastream

Past upward effect from lower euro is unwinding

The modest uptrend in core inflation has been basically reversed. There has been some

softening of service sector inflation, but the biggest move in the core basket was a sharp fall

-0.5

0.0

0.5

1.0

1.5

2.0

-6

-4

-2

0

2

4

6

8

06 07 08 09 10 11 12 13 14 15 16

import prices ex-energy (lhs) core cpi ind goods (rhs)

Group Economics Macro & Financial Markets Research

Nick Kounis

Head of Macro and Financial Markets

Research

Tel: +31 20 343 5616

nick.kounis @nl.abnamro.com

Arjen van Dijkhuizen

Senior Economist

Tel: +31 20 628 8052

arjen.van.dijkhuizen@nl.abnamro.com

Eurozone inflation turns negative again, while core inflation declines,

unwinding upward trend…

… we expect the ECB to ease policy more aggressively than the market

consensus

PBoC cuts RRR rate by 50bp – more targeted easing on the cards going

forward in China rather than bazooka

2 Daily Insight – Inflation report signals ECB should be bold - 1 March 2016

in core goods price inflation (to +0.3% yoy from +0.7%). The upswing in core goods prices

was a key factor behind the uptrend in the core. That reflected the delayed effect of the past

fall in the euro, which had pushed up ex-energy import prices. The relative strength of the

euro in recent months has seen ex-energy import prices coming down again, and with a lag,

this is now dampening core inflation.

Increasing risk of second round effects

Headline inflation is likely to remain stuck in negative territory in the immediate future, while

there is an increasing chance that second round effects from the fall in oil prices will further

dampen core inflation against the background of weak demand. Indeed, inflation

expectations have fallen sharply, while wage growth has also slowed.

ECB will act more aggressively than expected

We think that the weak inflation data adds to the already strong case for the ECB to

significantly step up its monetary stimulus. We think it will act more aggressively than

currently expected. Getting the euro back down is the only way to get core inflation up

significantly over the coming months, but that is not going to be easy given the Fed is likely

to be on hold and some ECB easing is already priced in. In addition, the ECB needs to

provide a strong signal that it will do whatever it takes in order to push up long-term inflation

expectations.

Our base case is that the ECB will cut its deposit rate by 20bp in March and by another

20bp in June. We expect measures to cushion the blow for banks. A tiered deposit rate

system and even longer duration refi loans look likely. Finally, we expect a EUR 10bn

increase in monthly asset purchases and an extension of the programme to June 2017. This

will be facilitated by removing the deposit rate floor for asset purchases.

PBoC steps up monetary stimulus

Staying with the theme of global reflation, the People’s Bank of China cut the required

reserve ratio by 50bp, freeing up liquidity in the banking system. The cut in RRRs, which

adds to monetary easing, should also be seen in reaction to capital outflows, which have

been curbing liquidity in the banking system. This RRR cuts fits in our base scenario, as we

expect RRR cuts (instead of policy rate cuts) to do most of the job in terms of further

monetary easing this year. More broadly, it seems that the PBoC has become more careful

with regard to using 'high-profile' benchmark interest rate cuts, given the uncertainties

regarding the exchange rate. The PBoC has for instance recently lowered interest rates

charged to banks on its medium-term borrowing facility, from 3% to 2.85%, while leaving the

benchmark policy rates unchanged.

We expect ongoing targeted easing rather than a monetary 'bazooka' from Beijing, as 'QE

China-style' would run counter to the longer-term goal of deleveraging.

We also expect the authorities to rely more strongly on fiscal stimulus, which was also

communicated during the G20 Summit and in the 13th Five Year Plan. In fact, China has

already stepped up its fiscal stimulus last year by raising infrastructure spending. We expect

the country's budget deficit to rise to 3% of GDP in 2016, up from around 2.5% of GDP in

2015.

3 Daily Insight – Inflation report signals ECB should be bold - 1 March 2016

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Day Date Time Country Key Economic Indicators and Events Period Latest outcome Consensus ABN AMRO

Monday 29/02/2016 00:50:00 JP Industrial production - % mom Jan P 3.7 2.8Monday 29/02/2016 11:00:00 EC CPI - % yoy Feb -0.2 0.2 -0.2Monday 29/02/2016 15:00:00 BE GDP - % qoq 4Q F 0.3Monday 29/02/2016 15:45:00 US Chicago Fed - business confidence - index Feb 47.6 52.3 52.0Monday 29/02/2016 16:00:00 US Pending home sales - % mom Jan -2.5 0.9 0.8

Tuesday 01/03/2016 00:30:00 JP Unemployment - % Jan 3.2 3.3Tuesday 01/03/2016 02:00:00 CN PMI manufacturing - index (official) Feb 49.4 49.4Tuesday 01/03/2016 02:00:00 CN PMI non-manufacturing - index (official) Feb 53.5Tuesday 01/03/2016 02:45:00 CN PMI manufacturing - index (Caixin) Feb 48.4 48.4Tuesday 01/03/2016 09:00:00 NE PMI Feb 52.4Tuesday 01/03/2016 09:55:00 DE Unemployment - % Feb 6.20 6.20Tuesday 01/03/2016 09:55:00 DE Unemployment change - thousands Feb -20.0 -8.3Tuesday 01/03/2016 10:00:00 EC PMI manufacturing - index Feb F 51.0 51.0Tuesday 01/03/2016 10:30:00 GB PMI manufacturing - index Feb 52.9 52.0 51Tuesday 01/03/2016 11:00:00 EC Unemployment - % Jan 10.4 10.4 10.4Tuesday 01/03/2016 15:45:00 US Markit - Flash PMI Feb F 51.0 Tuesday 01/03/2016 16:00:00 US ISM manufacturing - index Feb 48 49 49

Wednesday 02/03/2016 14:15:00 US ADP nat. employment report - thousands Feb 205.3 186.4 165Wednesday 02/03/2016 BR Policy rate - % Mar 2 14.3

Thursday 03/03/2016 02:45:00 CN PMI services - index (Caixin) Feb 52.4Thursday 03/03/2016 02:45:00 CN PMI composite - index (Caixin) Feb 50.1Thursday 03/03/2016 FR Unemployment (mainland France) - % 4Q 10.2Thursday 03/03/2016 10:00:00 EC PMI services - index Feb F 53.0 53.0Thursday 03/03/2016 10:00:00 EC Composite PMI output Feb F 52.7 52.7Thursday 03/03/2016 10:30:00 GB PMI services - index Feb 55.6 55.1 54.0Thursday 03/03/2016 11:00:00 EC Retail sales - % mom Jan 0.3 0.1 0.1Thursday 03/03/2016 13:00:00 BR GDP - % yoy 4Q -4.5Thursday 03/03/2016 14:30:00 US Output per hour nonfarm business sector - % qoq 4Q F -3.0 -3.3Thursday 03/03/2016 16:00:00 US ISM non-manufacturing, index Feb 53.5 53.4 52.0

Friday 04/03/2016 14:30:00 US Change in employment private employment - thousands Feb 158.0 188.0 165Friday 04/03/2016 14:30:00 US Change in employment total - thousands Feb 151.0 198.0 175Friday 04/03/2016 14:30:00 US Unemployment - % Feb 4.9 4.9 4.9Friday 04/03/2016 14:30:00 US Trade balance - USD bn Jan -43.4 -43.4

Source: Bloomberg, Reuters, ABN AMRO Group Economics (we provide own forecasts only for selected key variables and events)