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Chart 26: The Euro HICP - weighted index proportions recording Chart 27: Eurozone member country inflation rates, with bubble sizes inflation below 0% and above 2% proportionate to index weights 70 60 50 40 30 20 10 0 99 00 01 02 03 04 05 06 O7 08 09 10 11 12 13 14 15 16 — 2% —— «0% 4 0.5 1 1.5 2 Source: Eurostat, BofA Merrill Lynch Global Research Source: Eurostat, BofA Merrill Lynch Global Research Core inflation at 0.8% is barely above the 2015 low of 0.6%. One statistic that often grabs attention is the high proportion of HICP index components recording deflation (currently 31% on a weighted basis). However, much of this represents volatile non-core components so is less of a concern. The bigger problem is the fact that even after we take out all these components recording deflation, the 69% of the index remaining is only recording a weighted average inflation rate of 1.3%. Chart 26 shows that the more serious problem is that only 10% of components in the basket are recording inflation rates above the 2% target. So there is a “lowflation” clustering problem by index item and Chart 27 shows that there is also a lowflation clustering problem by country. In fact, the country clustering is even more concentrated than it looks if we allow for the fact that the bigger of the two upside outliers, Belgium (1.8% inflation), has experienced a presumably unrepeatable increase in the tax rate on electricity from 6% to 21%, as well as other excise duty increases. One might be tempted to give the Eurozone the benefit of the doubt on inflation, insofar as its output gap remains material. However, the closure of the output gap still requires strong and continuing stimulus, we would argue, and even that does not guarantee that somehow inflation resets to target. Our worry about item and country lowflation clustering is not that inflation is “unanchored”. Our concern is that it flags a “re-anchoring” of inflation at a level well below 2% and that this new anchor will prove difficult to dislodge. Chart 28: Output gap as % potential GDP Chart 29: Influence of current inflation on 5y5y EUR inflation swaps 0.35 0.30 0.25 0.20 0.15 0.10 0.05 0.00 0.05 -0.10 4% 3% 2% 1% 0% -1% -2% -3% 4% -5% ~6% 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 0415 pieaenieninittieneniaieien UK =—US 2009 2010 ——EA eee Confidence interval +/- 25D ’) Te Le o ooo? 2012-2013, 2014. 2015S 2016 Source: BofA Merrill Lynch Global Research , AMECO Note: The chart shows the slope of the regression of 5y5y on current inflation, with rolling windows of 29 quarters Source: BofA Merrill Lynch Global Research, Bloomberg 14 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 BankofAmerica <2” Merrill Lynch HOUSE_OVERSIGHT_014744