Investment Research

11 February 2011

Research
Euro area: Higher commodity prices may trigger ECB hikes
• This is the third paper in our research series on inflation. We now focus on the impact
Euro area inflation scenarios
of global commodity price changes on inflation in the euro area. In addition to our
2.8
main scenario we examine three scenarios: “The good”, “the bad” and “the ugly”. 2.6
% y/y
Ugly
2.4
• Inflation will remain above 2% throughout 2011 unless the good scenario with falling 2.2
Bad
commodity prices materialises. In the ugly scenario where commodity prices continue 2.0
1.8
to increase significantly, inflation will remain elevated in 2012 as well. 1.6 Main
1.4
• We find that global oil price increases impact euro-area inflation almost instantly 1.2
Good
1.0
while the impact of global food price increases comes with a substantial lag (about 10 jan-11 jul-11 jan-12 jul-12
months).
Source: EcoWin, Danske Markets
• Second-round effects are likely to be moderate, but should not be disregarded. In
Germany, where unemployment is low, commodity price increases may trigger higher
wage demands. In some of the countries with high unemployment, second round Euro area energy prices track Brent oil
effects will nevertheless materialise due to the inflation indexation of wages.

• The impact of rising food prices is higher in poorer countries than in the richer where
food accounts for a smaller share of consumption. The increase in prices erodes
purchasing power and thus dampens private consumption and growth prospects.

• In case of significant commodity price increases, we could soon see the ECB start
hiking interest rates. The mix of higher commodity prices and increasing interest rates
will dampen economic growth and further complicate the task of achieving
sustainable public finances. Source: EcoWin, Danske Markets

• If commodity prices fall back the ECB can keep rates unchanged for a prolonged
period. The lower commodity prices are positive for euro area growth and this will Energy price model
push core inflation upwards and eventually lead the ECB to start normalising rates.

• In our main scenario, inflation is just below 2% in 2012, but the outlook for inflation
will not be comfortable as a pick-up in core inflation is pushing inflation upwards
over the medium term. We expect the ECB to start hiking policy rates in Q4 2011.

Commodity prices are driving up inflation

The oil price has trended upwards since the beginning of 2009 and is now hovering
Source: EcoWin, Danske Markets
around USD100. Global food prices have also increased significantly due to increased
demand combined with very unstable weather patterns around the world. Wheat prices
are approaching their all-time high and the global CRB foodstuff index is even higher
than at its peak in mid-2008. It is still too early to say whether the elevated food prices
Senior Economist
have come to stay. The question is, whether the recent surge in prices is driven primarily Frank Øland Hansen
by increasing demand from emerging markets (the super-cycle theory), or whether it is +45 45 12 85 26
franh@danskebank.dk
due to a temporary supply shock caused by unfavourable weather. For a discussion on
this see our 9 February report: Global Inflation Scare: Commodities Super-cycle resumed. Economist
Anders Møller Jørgensen
+45 45 12 84 98
andjrg@danskebank.dk

Important disclosures and certifications are contained from page 6 of this report.

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In this paper we examine the implications for euro-area headline inflation and ECB policy
under different energy and food price scenarios. We refer to the scenarios as the good, the Brent oil scenarios
bad, and the ugly. Danske bank’s baseline scenario is also included as a reference point.
Note that Danske Bank’s baseline scenario for food and energy prices is not that far from
the super-cycle story, reflecting our belief that increasing demand is driving much of the
price increases and will continue to do so.

To ease interpretation and calculations we have not included any feedback from the
ECB’s policy response. Besides global food and energy prices everything else is equal.
For more on the different scenarios see the description in the appendix.
Energy price model Source: EcoWin, Danske Markets
An increase in global oil prices immediately triggers an increase in euro area energy
prices. In our energy price model a USD10 increase in Brent oil (keeping EUR/USD
unchanged) from the current level of about USD100 increases the HICP energy index by Euro area HICP energy inflation
1.2 percentage points in the same month and another 0.7 percentage points in the
12.0
% y/y
following month. Energy weights 9.5% in the overall HICP index and thus the direct 10.0
impact of a 10% increase in Brent oil is a 0.2 percentage point increase in euro-area 8.0

inflation. In addition to this there are second-round effects, which increase core inflation, 6.0 Ugly
Bad
cf. discussion below. 4.0

2.0
Main
Energy is heavily taxed and since a substantial part of the taxes on fuel are lump sum the 0.0
Good
impact of an increase in oil prices on inflation tends to be bigger at elevated oil price -2.0
jan-11 jul-11 jan-12 jul-12
levels. Our model does not take account of this, but is regularly recalibrated.
Source: EcoWin, Danske Markets
Food price model
The impact of global food prices on euro-area inflation is more difficult to model than the
impact of oil prices. The pass through from global food prices to euro area consumer Euro area food prices and global CRB
prices is slower and much of the volatility in global food price indices isn’t reflected in foodstuff index
consumer prices (in contrast to energy prices, where changes in global oil prices
immediately impact the prices at the nearest gas station).

The food price model captures the impact of changes in the global CRB foodstuff index
(in USD) on HICP food inflation. A 10% increase in CRB foodstuff is estimated to
increase euro area HICP food by 0.1 percentage point in the first month. The impact
peaks after 10 months with a 0.74 percentage point increase in HICP food inflation. Food
(including alcohol and tobacco) accounts for 19.2% of euro area HICP and thus the
impact of a 10% increase in CRB foodstuff is to raise euro area HICP by approximately Source: EcoWin, Danske Markets

0.14 percentage points after 10 months.

Second-round effects
Food price model
We expect second-round effects to be relatively limited due to the high unemployment
level in the euro zone throughout the forecast period. However, second-round effects
cannot be disregarded: in particular because there at the moment is an unfortunate mix of
countries either having wages linked to inflation or relatively tight labour markets.

In Belgium, Malta, Luxembourg and Cyprus, the automatic inflation indexation of wages
applies to all employees by law. In Spain and Portugal, despite not being formalised by
law, wage indexation is present in many collective agreements. Despite low wage
pressure in most of these countries due to high unemployment, the functioning of their
labour markets can thus lead to notable second-round effects from imported food and Source: EcoWin, Danske Markets
energy inflation.

In Germany, there is in general no automatic inflation wage indexation. However, the

relatively low and declining German unemployment level will at some point push up core
inflation and implies that the pass-through from commodity prices to wages will be

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stronger. This difference in the labour market across the euro zone combined with the
current state of the economies can increase second-round effects. Global CRB foodstuff scenarios

Baseline scenario
In our baseline scenario we project headline inflation to average 2.3% in 2011 and 1.8%
in 2012. The high inflation in 2011 is driven primarily by increasing energy and food
prices.

We have projected an increase in EUR/USD through 2011 to 1.45 in line with our official
FX forecast. The increase in EUR/USD dampens the impact of rising commodity prices
on euro-area inflation. In 2012 we have kept EUR/USD unchanged.
Source: EcoWin, Danske Markets
Core inflation is projected to increase slightly but to remain low throughout the forecast
period (1.3% in 2011, 1.5% in 2012). Despite strong growth in the core countries, large
regions within the euro area still suffer in the aftermath of the crisis. Thus the average Euro area HICP food inflation
unemployment rate has only just begun to decline and still stands as high as 10%. This
5.0
means little upward pressure on wages, an effect that can be seen in the low levels of core 4.5
% y/y
Ugly
inflation. 4.0
3.5

The good scenario 3.0

2.5
Bad

2.0
In the good scenario, global food and energy prices will, at the end of 2012, have 1.5
Main
decreased around 20% and 10% respectively, relative to primo 2011 level. The good 1.0
0.5 Good
scenario could materialise if OPEC reacts to current oil prices and expands production. At 0.0
jan-11 jul-11 jan-12 jul-12
the same time, fears regarding future supplies wane as technological advances reduce
expected future costs. Furthermore, food prices decline as plantings increase in response Source: EcoWin, Danske Markets

to current prices and capacity additions are made.

We estimate that such a decrease will imply a headline inflation of 2.2% in 2011 and
Euro area core inflation
1.2% in 2012. In this scenario, food and energy price inflation drag down headline
1.9
inflation as the core will be around 1.4% in 2012. This scenario increases the purchasing % y/y
1.8
power of consumers. If it is driven primarily by supply side factors such a decrease will Ugly
1.7

push global growth further. 1.6 Bad

1.5 Main
The bad scenario 1.4 Good
1.3
The "bad" case could happen if OPEC is slow to react and oil prices rise a little more than 1.2
in our base case. Simultaneously, La Niña persists and leads to further disruptions within 1.1
jan-11 jul-11 jan-12 jul-12
the agricultural sector, leading food prices to rise 1% m/m throughout our forecast
horizon. In the bad scenario, global food prices increase close to 30% while energy prices Source: EcoWin, Danske Markets

rise a little more than 25% until the end of 2012.

Our models suggest that the pass-through to headline inflation in the “bad-scenario”
HICP food weights across euro area
implies an inflation of 2.4% in 2011 and 2.0% in 2012. This scenario is not that far from
our baseline view, reflecting our expectation of a continued rise in energy and food-
prices.
The ugly scenario
Finally, in the ugly scenario the global increase in food and energy prices is a little more
than 60% and close to 40%, respectively, until the end of 2012. This scenario could
become a reality if the super-cycle proves strong and notably metal and energy prices lie
persistently higher for years to come. This could be associated with further restrictions on Source: EcoWin, Danske Markets
oil drilling outside of OPEC and little/delayed OPEC reaction to the higher prices,
implying Brent oil close to USD140 per barrel at the end of 2012. At the same time, a
series of unfavourable weather conditions combined with trade restrictions distort markets
and drive food prices further up.

In the ugly scenario, our model yields headline inflation that will stay above the ECB
target throughout our forecast period. Headline inflation is projected to be 2.5% in 2011

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and 2.3% in 2012. This scenario would be a nightmare for the ECB. Despite low wage
pressure within the euro zone, the ECB would have to hike rates to push core inflation Inflation across the euro area
further down to ensure that the imported inflation does not drive up headline inflation and
inflation expectations in the medium term.
Different impact across euro-zone member states
Inflation levels are very different within the euro zone. New euro-zone member, Estonia,
has had the biggest increase in prices since 2005 and is also currently topping the list with
an inflation of 5.3% in January. The country with the lowest inflation is currently Ireland
with inflation at 1.3%.
Source: EcoWin, Danske Markets
Different levels of income as well as differences in consumption patterns prompt the rise
in commodity prices to influence headline inflation differently. Food is a “normal good”
(income elasticity between 0 and 1). This means that as income increases relative
ECB does not hike simply because
spending on food decreases. On a national level, poorer countries spend a larger share of inflation is above 2%
their income on food. This is reflected by the weight on food in the HICP index. In the
three poorest countries (Estonia, Slovak Republic, and Malta (2009)) food constitutes
24%, while it makes up 18% in the three richest countries (Ireland, the Netherlands and
Austria (Luxembourg is left out)).

Germany and France have virtually the same income per capita, but while food accounts
for a bigger share of consumption in France than the euro area average, the share for
Germany is even lower than the average share for the three richest countries.

The surge in food prices thus affects the Estonian consumer more negatively than her Source: EcoWin, Danske Markets

German counterpart. The different weights to food in the consumption index also imply a
different effect of increasing food prices on headline inflation and are part (but only part)
Danske Bank expectations and market
of the story as to why the poorer countries in the euro area generally has the highest
pricing of ECB rate hikes
inflation at the moment, while the richer euro area countries tend to have the lowest.
ECB may hike if commodity prices continue to climb higher
Inflation has started to cause some concern for the European Central Bank. The
Maastricht Treaty dictates that price stability is the main objective of the ECB. In the
pursuit of price stability, the ECB aims at maintaining inflation rates below, but close to,
2% over the medium term.

The ECB focuses on headline inflation in contrast to the US Federal Reserve, which
focuses on core inflation. Inflation fuelled by increasing energy and food prices may thus Source: EcoWin, Danske Markets

result in the ECB hiking rates before the Fed.

The ECB does not hike simply because inflation is above 2%. In 2004-05 inflation was
above 2% in 19 out of 21 consecutive months before the ECB hiked rates. The inflation
outlook has to indicate that inflation will remain elevated over the medium term before
the ECB will initiate its hiking cycle. Even with the inflation outlook hovering just below
2% the ECB may eventually begin to normalise interest rates from the current
extraordinary low level as the output gap begins to close. This would be in line with the
“leaning against the wind” arguments that the ECB has frequently used to describe how
best to deal with the emergence of future bubbles.

In the bad and the ugly scenarios inflation will remain at or above 2% throughout the
forecast period. If these scenarios look to be likely to materialise, the ECB might start
hiking rates as early as this summer. The elevated commodity prices will impact
negatively on euro area growth, but this will not stop the ECB from hiking as it is very
committed to its inflation target. This could become a very unfortunate situation for the
periphery countries in particular. The mix of higher commodity prices, low growth and
increasing interest rates will further complicate the task of achieving sustainable public
finances.

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In our main scenario, inflation is below 2% in 2012, but the outlook for inflation will not
be comfortable as a pick-up in core inflation is pushing inflation upwards over the
medium term. We then expect the ECB to embark on its hiking cycle in the fourth quarter
this year. The market is pricing the first ECB hike in September 2011. We do not expect
the ECB to hike aggressively, probably 0.25 percentage points each quarter, which would
help it to lean against the wind as the output gap slowly closes.

In the good scenario, inflation will be subdued in 2012. In this scenario it is unlikely that
we would see the ECB start hiking any time soon. The lower commodity prices are
positive for euro area growth and this would push core inflation upwards and eventually
lead the ECB to start normalising interest rates.

Appendix - Commodity price scenarios: baseline, good, bad and

ugly
Besides our baseline scenario for energy and food prices (derived from our oil and grains
forecasts), we outline three scenarios that we believe are relevant to consider as
alternative paths for prices in order to judge the potential impact on the outlook for
growth and inflation in different regions.

Our baseline case is based on energy and food prices rising by around 20% and 15%,
respectively, by 2012 from current levels. Risks to our forecast for food prices do,
however, lie mainly on the upside as our current projection is conditional on little further
disruptions resulting from adverse weather effects.

The so-called second scenario - the "good" case – is beneficial from a consumer point of
view as this entails decreasing prices. Energy prices (measured in USD) decline 0.5%
m/m each month out to 2012 as OPEC reacts to current prices and expands production. At
the same time, fears regarding future supplies wane as technological advances reduce
expected future costs. Food prices decline 1% each month as plantings increase in
response to current prices and capacity additions are made.

The "bad" case is one in which OPEC is slow to react and oil prices thus continue to rise
by 1% m/m. Simultaneously, La Niña persists and leads to further disruptions within the
agricultural sector, leading food prices to rise 1% m/m throughout our forecast horizon.
Notably, this is not too far from our baseline view, which essentially falls in between the
good and the bad scenarios in terms of projected price changes.

Finally, a rather "ugly" outcome from a buyer’s point of view would be obtained if the
super-cycle proves strong. Indeed, the existence of a super-cycle suggests that the balance
of risks for notably metals and energy prices could lie persistently on the upside for years
to come. This could be associated with further restrictions on oil drilling outside of OPEC
and little/delayed OPEC reaction to prices, which could imply that oil will rise close to
1.3% m/m - notably implying Brent oil as close to USD140 per barrel end-2012. Equally,
a series of unfavourable weather conditions combined with trade restrictions could distort
markets and drive food prices up by 2% m/m.

For more details see link on page 1.

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Disclosure
This research report has been prepared by Danske Research, a division of Danske Bank A/S ("Danske Bank").
The authors of this research report are Frank Øland Hansen, Senior Economist and Anders Møller Jørgensen,
Economist.

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