More Global, Less Local
April 03, 2008
By Manoj Pradhan | London
Market-based measures of inflation expectations have eased in the last few weeks, with 10-year breakeven rates showing a dramatic 20bp decline in the US and a move into negative territory in Japan. The movement in 5-year 5-year forward breakeven rates has been even more dramatic in the US, while the euro area and the UK have seen smaller moves downward. We see three possible explanations: i) they may be of a technical nature, reflecting an unwinding of crowded long-breakeven inflation trades along with a general de-leveraging of balance sheets in March; ii) they may reflect a growing perception among investors that the Fed and other central banks will cut rates less aggressively than previously thought; and iii) lower-than-expected current inflation data in the US and/or weaker US economic activity indicators could have played a part in lowering inflation expectations. Looking forward, we believe that our call for higher inflation based on structural reasons is alive and well. The expected slowdown in the advanced economies may dampen cyclical inflationary pressures, but our research suggests that these domestic factors have lost ground to global inflationary forces.
Unwinding of positions may present opportunities. Technical factors such as the unwinding of widely popular yield curve steepening and long-breakeven inflation positions would certainly account for the activity in both areas in the past few weeks. Greater volatility, a lower willingness to take risk and general deleveraging would also have meant tighter stop-losses, which would contribute to these moves. Yet, if the underlying fundamental story is intact, which we believe is the case, then the narrowing of breakeven inflation rates should uncover value and better entry levels for investors who are willing and able to bet on higher longer-term inflation. Policy expectations have been reined in, but risks to rates are to the downside. The policy background has also been supportive of lower inflation expectations, as markets have priced in fewer cuts from the Fed, the ECB and the Bank of England, bringing market pricing closer to the policy paths outlined by our teams. Non-conventional action by the Fed to address the liquidity crunch, hawkish comments from the ECB and sustained attention by the Bank of England to inflationary pressures have pushed markets to price in fewer hikes for these central banks. In Japan, our team expects the Bank of Japan to cut rates in 2Q, a view that markets are warming to. Risks to the policy rate paths are generally – with the exception of Japan – to the downside, which means that risks to breakevens from this source are to the upside. In the developed world, where we expect recoupling (see Joachim Fels’ Recession, Recoupling and Reflation, March 26, 2008), central banks are likely to shift to easier monetary policies, pushing inflation expectations and breakevens higher. But what of slowing economic growth and its impact on inflation? Our US team expects core inflation to remain subdued because of a recession, with headline numbers having been revised upwards to reflect the buoyancy in oil prices. The latest CPI and PCE releases were consistent with this interpretation – core PCE inflation even eased by two-tenths to 2.0%Y in February. A counterpoint is the euro area economy, where HICP inflation has surprised to the upside, clocking in at 3.5%Y. With slower growth penciled in, our colleague Gerard Minack’s point that inflation will come down with a lag (see You Need Only One Worry, March 27, 2008) can be brought to bear. Similar arguments come into play for the slowing UK and Japanese economies. Where do we stand on these issues? We agree that slowing economies will dampen domestic inflation. However, the dampening impact of these factors is likely to be smaller than before. Instead, the structural factors that we have identified (see Joachim Fels and Manoj Pradhan’s A New Inflation Regime, March 5, 2008) are likely to push inflation higher. Any relief from a cyclical slowdown will therefore probably be muted and short-lived. Breakevens further along the curve should stay well supported by our structural inflation story. Our research suggests that global factors are now more important than domestic activity. In a previous note, we highlighted our research finding that global inflation is an increasingly important driver of domestic inflation (see Joachim Fels and Manoj Pradhan’s Inflation Goes Global, July 16, 2007). Our more recent research on this topic suggests that the relationship between global and domestic inflation has become more tight-knit since 1995. Not only does domestic inflation respond faster to changes in global inflation, but the latter has become a more influential driver of domestic inflation than domestic factors such as the output gap. Our estimates for the US and the euro area show that the impact of the domestic output gap on inflation has stayed relatively stable pre- and post-1995. In a nutshell, global inflation has become a much more important driver of domestic inflation since 1995, pushing domestic factors further down in the pecking order. If our estimates are anything to go by, then the structural case for inflation that we made stands firm. Globalisation, deregulation and the IT-led productivity boom had all been disinflationary forces pushing inflation lower. However, these factors may have recently turned inflationary instead. Global inflation, pulled higher by these factors, will tend to pull domestic inflation up along with it. The prominence of global factors going forward suggests that inflation will increase and stay higher. Breakeven inflation, particularly breakevens further out along the breakeven curve, should widen. If we are correct, this will put pressure on central banks’ inflation targets, which were set at a time when policymakers were basking in the benign, disinflationary glow of the above forces. Perhaps the biggest risk to the structural inflation call comes from the behaviour of volatile commodity prices. Sharply falling commodity prices would indeed take inflation down with them, but this would probably require a dramatic slowdown in emerging markets and a global recession – certainly not the view among our emerging markets teams or the market. If commodity prices stayed flat, their elevated level would result in some price and wage adjustment as compensation for producers and workers. Finally, not all commodities can be thrown into the same bushel – oil, hard and soft commodities are all expected to behave differently. A decline in all three would undoubtedly lower inflation, but the dramatically weaker global economy that would have to be the precursor to these moves does not seem to be on the cards.
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Surprising Resilience and Rising Inflation Risks
April 03, 2008
By Elga Bartsch | London
The euro area has shown surprising resilience in the face of the gales sweeping through financial markets. At the same time, there can be little doubt that the headwinds for the euro area economy are gaining strength. On the back of upward pressures on the money market and credit spreads as well as the currency and commodity prices, we recently lowered our GDP growth forecasts for the euro area to just 1.5% for both this year and next (see Euroland Economics: From Soft Rebalancing to Conflict of Interest, March 19, 2008). This downgrade clearly puts us – at least for now – below market consensus, below the ECB’s staff projections and below the official forecasting community. Despite our below-consensus growth forecast, we see only limited scope for ECB policy-easing in late 2008 and early 2009. If our forecasts for euro area GDP growth averaging 0.2%Q and thus falling significantly below trend between now and next spring are borne out by the data, and if consumer price inflation does indeed ease back towards the ECB comfort zone, we expect a total of 50bp of easing around the turn of the year. However, the markets, which have already re-priced the prospects of near-term ECB easing, are still pricing in more aggressive ECB action than we forecast. From a peak of nearly 80bp only two weeks ago, they are now pricing in 40bp before year-end. In our mind, they still have further re-pricing to do, we think. We expect that more forecasters to push back the timing of what would be the first ECB refi rate cut in this cycle on the back of the recent upside surprise in HICP and wage inflation, the robust money and credit growth and what, potentially, could be another hawkish press conference after the ECB Council meeting on April 10. While we expect a marked slowdown in GDP growth as the many headwinds work their way through the economy, the recent round of activity data has proved surprisingly resilient (see Euroland Business Cycle Watch: Resilience and Divergences, March 28, 2008). What looks like a stark disconnect between financial markets, on the one hand, and the real economy and the ECB, on the other, could just be a reflection of the long and variable time lags with which many of these external factors affect the economy. The impact of the tighter financing conditions may only become apparent once companies, who still enjoy strong record free cash flow, turn to the banks for funding. The impact of the stronger euro may only become clear once export prices reset, once the currency hedges expire or once customers have found another cheaper supplier. The full impact of the higher commodity prices will only be known once they have worked their way through all the production chains, once consumers receive their final energy bills for the year and once those heating oil tanks are emptied. In the meantime, the jury is out on the remarkable resilience of the euro area. Feeding the incoming business surveys into our GDP indicator would suggest potential upside risks to our GDP growth forecasts to the tune of about half a percentage point between now and the end of the third quarter. As our GDP indicator is a real time estimate, updated on a monthly basis in our Euroland Business Cycle Watch, our conjecture is that the indicator will come down in the coming months as business sentiment is likely to deteriorate further. This holds true, in particular for 3Q, where the gap between the indicator and our forecast is biggest and where the estimate –at this stage – is based only on an incomplete set of data points. The stumbling block between the ECB and rate cuts right now is the upside surprises on HICP and wage inflation. Based on a first flash estimate, HICP inflation surged to 3.5%Y in March, marking a new record for the EMU area and a 16-year high if one goes back to the pre-EMU days. This clearly puts headline inflation way above the ECB’s comfort zone of an annual inflation rate below but close to 2%. Barring any major collapse in commodity prices, inflation will likely stay above the ECB’s comfort zone both this year and next. At this stage, it seems likely that inflation will only ease moderately to around 2.7% by the end of this year. Bear in mind that Euroland inflation tends to be more persistent than, say, US inflation. Therefore, it might take a larger negative shock to GDP growth to lower inflation than it would, for example, in the US. Against a backdrop of high capacity utilisation rates (at 84.2%, it stands more than one standard deviation above its long-term average of 81.9%), an unemployment rate of only 7.1% of the labour force and elevated, if not rising, inflation expectations, the ECB remains concerned about second-round effects. The pay deal reached in the German public sector, which will see wages and salaries rising by at least 5.1% this year and another 2.8% in January 2009, will likely reinforce these concerns. Of course, public sector wages are often more of budget risk than a direct inflation risk. But the juicy pay deal will likely fire up trade unions in other sectors and it will also bolster domestic demand growth. Meanwhile, Italy reported a noticeable pick-up in wage inflation to 3.1%Y in February, up from 2.1%Y in January. At the heart of the debate is how the credit crunch will affect credit availability to the non-financial sector. Given the rapid expansion of the financial sector in recent years, the answer to this question is not obvious. What is clear though is that so far there is little evidence of credit supply, notably to non-financial corporates, being significantly impaired. February saw M3 growth holding broadly steady at 11.3%Y and loans to the private sector hovering around a broadly stable level of 10.9%Y. Hence, the marked tightening in credit conditions reported in the bank lending survey still needs to feed through into actual lending dynamics. Apart from outstanding bank loans, the new lending business summarised in MFI interest rate statistics also does not show signs of a significant impairment in credit supply to the private, non-financial sector (see EuroTower Insights: Cracking the Credit Puzzle, March 3, 2008). The introduction of additional six-month refi operations shows that the ECB is determined to ease money market tensions through additional liquidity operations rather than policy rate reductions. The ECB decided to offer supplementary longer‑term refinancing operations (LTROs) with a maturity of six months, in addition to further supplementary LTROs with a three-month maturity. The regular monthly LTROs remain unaffected. The supplementary three-month and six-month operations will be carried out as a variable-rate standard tender procedure with preset amounts. There will be a first supplementary six-month LTRO of €25 billion this week. Two new supplementary three-month LTROs, of €50 billion each, will replace the two currently outstanding supplementary three-month refis of €60 billion. The ECB has already significantly altered the maturity mix of its refi ops, flipping around the traditional mix of two-thirds weekly and one-third three-monthly. If signs of an impairment of credit supply to the non-financial sector were to emerge, this would likely induce the ECB to move more aggressively than our current forecasts and its communications would suggest. In the ECB’s two-pillar strategy, any change in money and credit dynamics would immediately affect the bank’s medium- to long-term assessment of the risks to price stability. So far, however, these changes in bank lending dynamics remain elusive. The same will likely hold true for near-term ECB rate cuts.
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