Forex Analysis & Reviews: 01.12.2022 - EUR/USD. Inflation whispers,...

01.12.2022 12:00 AM

EUR/USD. Inflation whispers, the ECB's rat race

The euro is struggling to develop a rally despite weakness in the U.S. currency. Growth is limited by incoming data on the euro bloc, indicating that the ECB will not need to apply harsh measures at its upcoming interest rate meeting in December.

Eurostat reported that the eurozone inflation rate eased slightly to 10% in November, lower than the consensus forecast. Market players had expected an increase of 10.4% on an annualized basis. The previous month's inflation was recorded at 10.6%. There is clearly a slowdown in the rate of price growth.

In monthly terms the figures do not look so pessimistic either. After the previous increase of 1.5%, the current decrease of 0.1% is a good thing.

Traders were prepared for declining pressure in prices as Spain, Germany and Belgium reported similar declines on Tuesday. It is still unclear how realistic further price cuts look.

Core inflation is set at 5%, well above the 2% the European Central Bank would prefer. The central bank is unlikely to relax. Policy tightening is likely to continue, albeit at a slower pace.

Investors started to bet on a 50 bps rate hike. At the previous meeting it was raised as much as ever by 75 bps.

"While we're far from out of the woods yet, it does look like the current economic environment could push the European Central Bank to a smaller 50 bp hike next month," ING economist Bert Colijn said.

The core inflation rate is still unchanged. This excludes volatile elements like price changes in food and energy and therefore can be considered a more meaningful indicator of inflation for the ECB.

Although this month was free of unpleasant surprises, it is too early to draw conclusions. No one can guarantee the peak of inflation, so investors will probably have to take a wait-and-see approach.

"Another episode in the energy crisis could easily push inflation back up again and core inflation usually proved to be sticky after a supply shock," ING believes.

Not all economists hold this view. For example, UniCredit Bank believes that in 2023 inflation in the euro area should slow down quickly. According to calculations, inflation will remain above 10% on an annualized basis until the end of the year, and then begin the path of decline, which will lead to 2.5% by the end of 2023 and to 2% by mid-2024.

"Base effects, broad stabilization in commodity prices, demand compression and a further easing of bottlenecks are likely to be the main drivers of the deceleration," says Marco Valli, Chief European Economist at UniCredit Bank.

The ECB estimates that about half of the core inflation rate is attributable to supply-side factors. Valli says as these factors gradually fade and demand weakens, core prices are likely to adjust downwards as well.

The ECB's move to a slower rate hike may be justified. However, according to economists, two main conditions must be fulfilled before the central bank can halt its rate hikes: 1. evidence that core inflation has peaked; and 2. the unemployment rate starting to rise.

"We expect that both conditions will be met sometime over the course of 1Q23," Valli adds.

UniCredit looks for a peak level for the ECB's deposit rate at 2.75%, with 50 bp hikes in December and February and a final 25 bp move in March.

As for the short-term outlook, Federal Reserve Chairman Jerome Powell will intervene in the EUR/USD.

The uptrend line for EUR/USD is near the 1.0450 level. If the quote rises higher and uses it as support, it will be able to aim for the psychological level of 1.0500.

Speaking about the downtrend, it is worth noting that the nearest support is located at 1.0350 before 1.0300, then 1.0280.

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