The start of the year was characterized by declining inflation expectations. Economists scaled back inflation forecasts, and market-derived measures of inflation expectations fell in lock-step with sliding oil prices. More recently there have been a number of signs of a little more inflation. US core inflation accelerated to 1.7% yoy in February from 1.4% at the end of last year. Eurozone core inflation rose to 1% in March from 0.8% in February, reversing the previous month’s drop. At the same time, commodity prices are up by around 10% from their February low. Finally, the CPB’s measure of global manufactured goods prices reported a slower pace of deflation in January. Does all this mean global inflation is turning?
Unemployment is coming down in the eurozone but from very high levels and it is unlikely there will be strong wage pressures any time soon.
Nick Kounis Head of Macro Research
- Recent inflation reports in the US and eurozone have been firmer, commodity prices are up and global goods deflation has eased
- Although headline inflation will turn up later in the year, underlying inflationary pressures will likely remain subdued
- Global economic growth remains lacklustre, while overcapacity in China’s industrial sector will remain a disinflationary force
- Wage growth is moderate in the US and weak in the eurozone and some of the recent rise in consumer prices is driven by special factors
Headline inflation will rise later in the year
It seems likely that headline inflation will rise later in the year. This is largely a matter of mathematics rather than economics. Our base case is that oil prices will rise gradually during the course of this year. However, even if oil prices were to remain flat at current levels, the year-over-year rate of energy inflation will eventually gravitate to zero, from the deeply negative rates we see now. This means that the drag on inflation from energy prices will fade in the second half of the year unless oil prices fall significantly further. So although headline inflation may not have turned just yet, it most likely will do so after the Summer.
Special factors at play
Having said that, underlying inflationary pressures are likely to remain subdued. This means that headline inflation will eventually settle at low levels following the unwinding of the energy price drag. To start with, recent rises in core inflation may well have been inflated by temporary factors. This is especially true in Europe. Inflation was likely pushed up by the early timing of Easter this year, and this effect will more than reverse in April, before normality returns in May. Although we only have broad aggregates, service sector inflation (which jumped to 1.3% from 0.9%) was probably most impacted. Details from the German states for instance, point to a surge in the prices of package holidays. On the other side of the Atlantic, medical costs are a factor that has put upward pressure on inflation, which may not be sustained.
Global goods prices likely to remain weak
In addition, it does not seem likely that global goods prices are set for an imminent upswing. Though there have been some signs of improvement recently, global industrial production remains weak, and usually leads global prices. So even if we see a moderate recovery in production it would take time for it to lift prices. Furthermore, there may be currently some specific factors dampening prices. China – often dubbed the world’s factory – is still suffering from industrial overcapacity. Although China’s industrial profits rose in February for the first time since December 2012, it is much too early to claim this will be sustained. In particular, Chinese manufactured goods prices continue to decrease at a sharp pace.
US wage growth modest despite strong job growth
Finally, over time the main driver of inflation tends to be domestic in nature. In particular, higher wage growth is crucial to driving a sustained upward trend in core inflation. Yet wage growth is modest in the US at just 2.3% yoy in March, even though employment growth has remained strong (it came in at 215K in March following 245K in February). One reason for this apparent inconsistency is that the labour market is no longer tightening. The unemployment rate has been at either 4.9% or 5% for the last six months in a row. This reflects that stronger labour supply (the labour force participation rate has risen for four months in a row) is meeting the increased labour demand. Going forward we expect this situation to continue, with the unemployment rate roughly stable, not least because job growth will probably lose some pace to reflect slower economic growth and declining profits. In the eurozone, wage growth is even weaker, at around 1.5%. Unemployment is coming down in the eurozone but from very high levels and it is unlikely there will be strong wage pressures any time soon.