Inflation fell broadly in many economies around the world in February. We expect the disinflationary trends to continue in the near term, but inflation should stabilise in the second half of the year and start to slowly move up again by the end of the year. The most important factor behind this view is the US-led global economic recovery. On a global level, low inflation is not necessarily a bad thing as it gives central bankers the possibility to set monetary policy that is supportive to economic growth. In the US, we think inflation will move towards the Fed’s goal next year. In the eurozone and Japan, the situation is more worrying as core inflation is particularly low and economic growth is more moderate. As long as the economic recovery in both countries continues and currencies fall versus the dollar, deflation should be a avoided.
Inflation fell broadly in many economies around the world in February
Nick Kounis Head of Macro Research
This week's column was written by Nick Kounis, as Han de Jong is away.
Subdued inflation trends…
The latest round of reports around the world show that inflation remains well under control and below central bank targets. US inflation fell to 1.1% in February from 1.6% in January. The fall in inflation was down to lower energy prices compared to last year, while core inflation remained unchanged at 1.6%. The personal consumption deflator – the alternative measure of inflation that the Federal Reserve is focused on – stood at 1.2% in January, with the core at 1.1%. This is below the Fed’s inflation goal of 2%. Meanwhile, eurozone inflation fell to 0.7% in February from 0.8% in January, marking a downward revision from the flash estimate that inflation was unchanged at 0.8%. The decline in inflation was also due to a decline in energy price inflation, while the core was steady at 1%. Within the eurozone, inflation slowed in most member states, with France being the exception among the big countries, reflecting some delayed upward impact from the VAT hike at the start of the year. In absolute terms, year-over-year inflation rates are negative in Greece (-0.9%), Cyprus (-1.3%) and Portugal (-0.1%). The rate of inflation is close to zero in Spain and Ireland (+0.1%), and very modest in Italy and the Netherlands (+0.4%). On the other end of the spectrum, Austria (1.5%), France (1.1%), Germany and Belgium (both 1%) have higher rates of inflation than the average, though no eurozone member state had an inflation rate in line with the ECB’s mandate of close to but below 2%.
…around the world
Meanwhile, China’s inflation rate fell to 2% in February from 2.5% in January, leaving it well below the government’s target of 3.5% for this year. Japan’s inflation rate fell to 1.4% in January from 1.6%, while ex-food and energy it was stable at 0.7%. Japanese inflation has steadily climbed out of negative territory over recent months, but it remains far off the BoJ’s 2% target.
The dog that did not bite
Since the financial crisis, central banks have adopted a whole series of measures to fight systemic risks and revitalise economic growth. The combined balance sheet of the Fed, the ECB, BoJ and BoE has risen to almost ten trillion dollars from three and a half trillion pre-crisis. This raised concerns that these policies would work too well and in the end generate excessively high inflation. However, with credit growth in most advanced economies still low, broad measures of the money supply have remained modest. Indeed, the bigger issue in recent months has been about whether inflation could turn out to be too low, certainly in the eurozone.
Factors driving inflation lower
A number of factors have been driving inflation lower globally. First of all, global growth has been modest over recent years, and has been below trend in many advanced economies. This means that the high levels of economic slack that built up during the crisis have not been absorbed very quickly. Of course there are differences between economies, with unemployment still high and hardly having come down at all in the eurozone, but having dropped significantly in the US. Within the eurozone there are large differences as well, with Southern European countries generally having much larger amounts of slack that their northern counterparts. Meanwhile, in China, the investment boom over recent years has created excess capacity in a number of industrial sectors. China’s producer prices were down 2% yoy in February. Finally, commodity prices have generally trended lower, reflecting moderate economic growth and increasing supply in many markets. The above factors have seen global manufactured goods prices falling in both 2012 and 2013. The pace of global manufactured goods price deflation remains significant, having reached 2.9% in December.
End of disinflation later this year
We expect the disinflationary trends to continue in the near term, but inflation should stabilise in the second half of the year and start to slowly move up again by the end of the year. The most important factor behind this view is the US-led global economic recovery. In the US, unemployment has fallen to levels that is triggering a gradual rise in wage growth. Currently, it is still not significantly exceeding productivity growth, which means that unit labour costs are still flat. However, this should increasingly happen as the labour market gains strength during the course of this year. A turn in the global manufacturing and trade cycle should also start to reduce disinflationary pressures. In addition, the US should start to export inflation elsewhere as the dollar strengthens broadly, but especially against the euro and the yen. Thirdly, the impact of commodity prices on inflation should become more neutral later in the year. On the one hand, we expect oil prices to decline. On the other hand, wholesale food prices, which feed through to retail food prices with a lag, have stopped falling recently.
Concerns about low inflation in eurozone and Japan
On a global level, low inflation is not necessarily a bad thing as it gives central bankers the possibility to set monetary policy that is supportive to economic growth. In the US, we think inflation will move towards the Fed’s goal next year. In the eurozone and Japan, the situation is more worrying as core inflation is particularly low and economic growth is more moderate. As long as the economic recovery in both countries continues and currencies fall back versus the dollar, deflation should be a avoided. However, in case of a negative economic shock, risks of deflation in the eurozone and a return to deflation in Japan would be large. A proactive approach by these economies’ respective central banks makes sense to manage these risks. The BoJ is already expanding its balance sheet aggressively and stands ready to act if next month’s sales tax hike undermines the recovery. The ECB has also signalled it is ready to move, but seems content to sit on its hands and hope for the best.
Fed Chair Yellen and the 'six months' comment
The new Chair of the Federal Reserve Janet Yellen caused a stir on financial markets in comments during the press conference following the FOMC. She said that rates could start to go up around six months following the end of asset purchases. Asset purchases will end in October if the current pace of tapering continues, which means that rates could go up in the second quarter of next year if we take her comments literally. A debate followed these remarks about whether the comments were deliberate or were simply blunder. The slip up explanation seems the less likely one. Ms Yellen has many years of experience at the Fed, serving as vice Chair since 2010, and has worked for the organisation on and off in various capacities since 1977. She is not exactly a novice when it comes to Fed speak. In addition, the FOMC has spent many hours discussion various strategies to shape market expectations of the future path of short term interest rates. It would be especially odd if the Fed Chair would be careless about communication on this topic. One possibility raised by the remarks is that the Fed intends to start early with rate hikes but then proceed slowly. The FOMC expects rates to reach 1% by the end of 2015. If it was to start in say April, it could subsequently raise rates every other meeting. This would be slower than the last rate hike cycle, when we saw 25bp step moves at each meeting. Our base scenario is that the Fed will start to hike rates in June and will move rates up to 1.5% by the end of next year, which is faster than markets are currently pricing in (see next section on Rates for more on this).
US economic data start to thaw
There was not that much macro data to mention from last week. However, the few reports we had suggested that the US economy is starting to shake off the effects of the bad weather, which has impacted the data to various degrees between December of last year and February of this year. Two regional manufacturing surveys (The Philly Fed and New Yorks’ Empire State) rose in March. Meanwhile, initial jobless claims edged up only slightly in the week ending 15 March, consolidating the falls seen in previous weeks, and signalling stronger job growth this month. Hard data for February were mixed, with manufacturing output rebounding strongly, but housing sales and starts failing to pick up following sharp falls in January. Our view remains that US fundamentals are healthy and that economic growth will accelerate strongly from weather-related weakness.
Weak China PMI sets scene for stimulus
Data published over the weekend showed that China’s flash manufacturing PMI unexpectedly fell to 48.1 in March from 48.5 in February. The consensus was for a rise, probably based on the view that the Lunar New Year had previously distorted the data to the downside. Although the PMI surveys are not as good at tracking economic growth as their counterparts in advanced economies, we do think that this is a sign that the authorities will treat seriously. Indeed, the last time the PMI fell to around these levels (in the summer of last year) we saw a macroeconomic policy stimulus and it seems likely that we will see a similar response this time as the authorities attempt to keep growth close to their 7.5% target. The authorities are already planning to bring forward investment projects, as part of the ‘New Urbanisation Reforms’, which is very much in line with the idea that the economy needs some help.