Eurozone inflation turned negative, while inflation is low in most big economies even outside of energy prices. The eurozone in particular could do with more inflation and QE is the only tool the ECB has. Higher inflation targets would give central backs more room to employ conventional monetary policy as it would allow them to slash real interest rates.
The 2% targets have not provided central banks with enough of a buffer on the downside against the background of various shocks
Nick Kounis Head of Macro Research
Eurozone inflation back in the red
This week was marked by figures showing that eurozone inflation turned negative again in September. Headline inflation fell to -0.1% yoy from +0.1% in August. That was mainly due to a hefty drop in energy prices. It would be difficult to complain about that, given it means a windfall gain for consumers. Having said that, inflation is too low outside of volatile food and energy prices. Core inflation stood at just 0.9% yoy, basically less than half the level the ECB targets over the medium term for overall inflation.
Low inflation is a world-wide phenomenon. Headline inflation in Japan also recently turned negative, with the ex-food measure that the BoJ targets at -0.1% yoy in August. Ex food and energy inflation firmed, but to a still low 0.8%. Inflation is also low even in economies further ahead in the cycle. In the US, the core PCE deflator, targeted by the Fed to be 2%, stood at 1.3% in August. UK inflation was 0% in August, while the core was at 1%. Even in many emerging markets, inflation is relatively low. China's consumer price inflation stood at 2% yoy in August, while producer prices were down by a breath-taking 5.9% yoy. Indian CPI inflation was running at 3.7% yoy in August, while wholesale prices were down by 5% yoy. Only in Brazil and Russia is inflation high among bigger economies, partly reflecting a slump in their currencies.
The death of inflation
Central bankers spent the 1980s and part of the 1990s trying to slay inflation. Legendary Fed Chairman Paul Volker raised interest rates sharply to push down inflation. More generally central banks introduced implicit and eventually explicit inflation goals. Helped by the entry of China in to the global trade system as a low cost manufacturing powerhouse, these efforts proved remarkably successful. It can be argued that they were too successful. All the major central banks in advanced economies have adopted inflation goals of 2%. This seemed a reasonable level in the past, but it can and should be questioned today.
The downside of lowflation
The 2% targets have not provided central banks with enough of a buffer on the downside against the background of various shocks. In particular, it is real interest rates that matter for the economy and the lower the level of inflation, the high the level of real interest rates. This becomes a problem especially given the limited room that central bankers generally see for taking nominal rates below zero. The problem may have become more acute recently as lower trend growth means that neutral interest rates are also lower.
Challenges for monetary policy
Take the example of the eurozone. Trend growth may have come down by around 1% over recent years, from just over 2% in the years before the crisis to just over 1% currently. The neutral rate may also have come down by around the same amount, from around 3.5% pre-crisis to around 2.5% now. Given the inflation goal of the ECB, that means the real neutral rate is now at just 0.5%. This means that to get conventional monetary policy stimulative, real interest rates need to become deeply negative. However, that is not possible given current low levels of inflation and an effectively zero nominal bound. Some notable economists - including Larry Summers and Olivier Blanchard - have made the case for higher inflation targets over recent years because of this dilemma. For instance, a 4% inflation target would given much more room for real rates to drop.
For now QE is the only game in town
Given where we are now, QE is the only option the ECB has to ease monetary conditions and that comes with its own problems. A stepping up of asset purchases seems likely in the coming months. To get inflation back up, it needs to generate domestic inflationary pressures to offset external disinflationary forces. This week data showed the unemployment rate stable at 11% in September. Still unemployment remains on a downward trend, and wages seem to be firming. Still there is a long way to go to generate significant domestic inflationary forces in the eurozone. In the meantime, the risk is that the inflation expectations of households, companies and investors decline, making it even more difficult for the ECB to meet its inflation goal. In essence, low inflation could become a self-fulfilling prophesy.
US and UK labour markets closer to generating inflation
The US and UK are further ahead in this process of course. The US labour market continues to improve. This week’s data showed that growth in non-farm payrolls disappointed in September (142K, following 136K in August), but we still think the recovery of the US labour market remains on track, although the pace of the recovery seems to have shifted down a touch recently. Meanwhile, the UK labour market looks to be already starting to push up inflation. Unit labour costs rose by 2.2% in Q2 up from 0.3% in Q1. The tightening labour market finally seems to be pushing up wages. We expect this to develop in the US as well in the coming months.
External disinflationary forces
The global economy is currently a source of significant disinflationary pressure. It is not only commodity prices that are falling. Global manufactured goods prices have also been falling sharply. This partly reflects over-capacity in China's industrial sector. However, falling commodity prices also seem to be feeding through into producer prices, while manufacturing activity has also been weak. The global manufacturing PMI fell to 50.6 in September from 50.7 in August, taking it to its lowest level since July 2013. The output price index fell further below the 50-mark last month. For the US, the strength of the dollar is adding to these disinflationary forces.
Another round of euro weakness would help
In the case of the eurozone, euro weakness had been offsetting weakness in global prices. However, the euro's levelling out over recent months means that this is no longer the case. Eurozone producer prices excluding energy fell by 0.5% yoy in August. Another round of QE would be helpful in generating a new downward leg for the euro. The eurozone could do with some extra upward pressures on inflation given that it is further away from generating significant domestic inflationary pressure than the UK or the US. If the Fed (December) and the BoE (February 2016) start to raise rates as we expect that should also be helpful in triggering further euro weakness.
Manufacturing weak, services better
The dichotomy between external and domestic developments is also visible in the difference in the trends between activity in manufacturing and services. The eurozone manufacturing PMI was down to 52 in September from 52.3 in August. The services PMI also declined but remained at a more healthy level of 54. Similarly, German factory orders declined in August. Although domestic orders and orders from the rest of the eurozone rose, there was a slump in orders from outside of the eurozone. The US ISM manufacturing index fell to 50.2 in September from 51.1 in August, taking it to the lowest level since May 2013. Weaker global demand, dollar strength and cut backs in oil sector investment have hurt industry. On the other hand, most indicators suggest that domestic demand remains strong.
China and EM risks
The PMI reports out of China were rather mixed, but in general emphasised the downside risks to the economy. The Caixin and official NBS manufacturing PMIs were roughly steady in September, but that left them at low levels consistent with weak industrial sector growth. Although the NBS services PMI remained at decent levels, its Caixin counterpart showed a sharp slowdown. The latter raises the risk that the weakness in the economy is broadening. Still we continue to think that policymakers have the tools to keep the slowdown gradual and that they will employ them. Wider emerging market risks were also emphasised this week. Emerging market PMIs remained soft in September. At the same time the Institute of International Finance warned that emerging markets would see a net capital outflow of USD 540 bn this year. This would be the first net outflow since 1988. EMs generally have higher FX reserves than in the past, which should allow them to avoid a systemic crisis. However capital outflows lead to a tightening of financial conditions, which is weighing on growth. Overall, our base case scenario is for continued but moderate global economic growth as waning EM growth is offset by a gradual recovery in the advanced economies.