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What to Watch: Lower Oil Prices May Hasten ECB, Stall BOE

Latest drop in oil prices means the widely expected rebound in inflation may not materialize in the months ahead

Fresh oil price weakness has lowered the bar for further ECB easing while the BOE is now less likely to raise rates as soon as May, economists say.

Oil is down more than 30 percent from a year ago and analysts from BofA to Morgan Stanley say prices could fall to as low as $20.

The ECB's accounts of its December meeting, and the BOE rate decision and minutes are due tomorrow.

Why falling oil prices matter 

If oil prices stay where they are, inflation in the euro area may be back to negative by mid-2016 and around zero in the second half of 2016, Ruben Segura-Cayuela, economist at BofA says in interview.

Expect U.K. inflation to pick up but stay below 1 percent until the second half of the year, as long as oil prices don’t fall further, BofA economist Rob Wood says in interview.

UBS’s Reinhard Cluse points out that uncertainty around the outlook for oil prices means there's a two-way risk to inflation forecasts. If oil was to rebound to $55 per barrel-$60 per barrel, that would suggest inflation could move to 2 percent by end-2016, he said.

What is happening to inflation expectations

Significant risks to inflation expectations are materializing with Commerzbank’s preferred measure approaching pre-QE levels, analysts at the bank write in a client note.

The fall in oil prices is likely to lead to significant changes in expectations for inflation in 2016, particularly the early months when central banks had been expecting an increase, Credit Suisse economist Neville Hill says in interview. The key take-away is more volatility in inflation expectations in 2016, he says.

EUR 5y5y inflation swap is at 1.63 percent versus a four-month peak of 1.81 percent on Dec. 1, and below where it was in the weeks before Europe's central bank started so-called QE last year. GBP swaps are at 3.30 percent, down 6bps year-to-date.

Economists at UBS and BofA have already cut their euro-area inflation forecasts to reflect the leg lower in oil prices.

What this means for the ECB

BofA already expects ECB to ease further in the second quarter of the year, and says lower oil prices will help to build consensus for more action within the central bank. ECB’s inflation forecasts already look difficult to achieve, Segura-Cayuela says.

The hurdle for more ECB easing probably isn't very high and the discussion about doing more may gain momentum in the run-up to the March 10 policy meeting, UBS’s Cluse writes in a note.

The risk of verbal intervention has risen as current market-based inflation expectations directly challenge Draghi’s inflation credentials, Commerzbank analysts say.

The ECB may ease further as inflation is set to disappoint amid a further fall in oil prices, while core inflation may miss ECB staff expectations. This week’s accounts of the ECB’s December meeting may clarify the confusing messages last month, JPMorgan economists write in a note.

Credit Suisse’s Hill is maintaining his view for no further ECB easing this year, despite the oil price move. As long as the oil price fall is related to China’s market volatility rather than a downturn in the Chinese economy, it’s net positive for Europe’s cyclical data. That suggests PMIs may not be weak enough to bring the ECB to the table, he says.

What about the BOE?

BofA pushes back its call for the first BOE rate rise to November 2016 versus May previously, due partly to oil prices and partly to Brexit uncertainties, Wood says in interview.

Goldman Sachs also pushed back its rate rise forecast to the fourth quarter from the second quarter previously, to reflect the fall in commodity prices.

Economists at Deutsche Bank and JPMorgan say their expectations the MPC will lift rates in the second quarter of this year are looking vulnerable.

RBC analyst Sam Hill says the BOE’s sole hawkish dissenter, Ian McCafferty, may wait until February’s Inflation Report to drop his vote for rate rises, but could change his mind as soon as this week.

BofA’s Wood says the real trickiness for BOE is that unemployment keeps falling and the MPC's argument that they can wait to lift rates gets trickier the lower unemployment goes.

While there’s short-term risk, some MPC members may voice the idea of a rate cut in the months ahead, Credit Suisse’s Hill says. A re-acceleration in pay growth further out may cause volatility as market has gone a long way in pricing out rate increases, he says.

What about other central banks?

JPMorgan economists estimate the odds of a Riksbank rate cut are close to 50 percent. They point out the central bank held an extraordinary meeting, and announced it’s ready to intervene in the foreign-exchange market to limit upward pressure on the krona.

The slide in oil prices is also pushing the Norges Bank to act, JPMorgan economists add. They forecast a 25-basis-point rate cut in the second quarter of this year, and say the probability of a move in March is rising.

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