Chart of the month - December
Janet Mui, Global Economist, looks at where inflation is heading and what it means for monetary policy
- Both headline and core consumer price (CPI) inflation look set to grind higher in the US during 2018, and there is potential for more hawkish policy reaction from the Fed should inflation surprise to the upside.
- UK headline and core CPI inflation rates are likely to subside during 2018. While another rate hike in 2018 seems appropriate, the rapid erosion of spare capacity would test the Bank of England’s resolve.
- Headline and core inflation in the eurozone are likely to trend steadily higher during 2018, but still remain below the European Central Bank’s (ECB) inflation target. Policy looks set to remain relatively accommodative in 2018.
US – increased risk to inflation, the Fed may turn more hawkish than expected
Both headline and core consumer price (CPI) inflation look set to grind higher in the US during 2018. The increase in inflation partly reflects the unwinding of some temporarily weak factors, but also the impact of higher energy prices and the continued tightening of the labour market. In addition, the combination of the weaker US dollar and the pick-up in producer prices is likely to reverse the prevailing trend in core goods prices, currently -1.0% year on year (YoY). Surprisingly, the near 30% YoY rise in oil prices will add only modestly to headline inflation (+0.2% YoY), with the maximum impact coming through in Q2 2018 (assuming current prices are maintained). Of more concern is that robust economic activity and the tightening labour market are likely to generate more obvious increased pressure on labour costs.
Taking all these various influences into account, it would seem that the risks to US inflation are higher than expected. Furthermore, with the economy already operating at near full capacity, tax cuts for households and corporates are likely to provide additional economic activity during 2018.
The Federal Reserve (Fed) has pencilled in three interest rate increases in 2018, without factoring in the impact of tax reform. Clearly, should inflation increase more than anticipated, there is the potential for an even more hawkish policy reaction from the Fed.
UK – inflation set to slow markedly, one more rate hike is likely in 2018
In the UK, headline and core CPI inflation rates are likely to subside during 2018. Headline inflation hit 3% in 2017, mainly as a result of the post-referendum slide in the value of sterling and the consequent rise in import prices. This showed through most obviously in a surge in goods price inflation from -1.8% in May 2016 to +3.3% by October 2017. On the other hand, and probably reflecting a more subdued consumer environment, services inflation, currently running at 2.7%, did not move much in 2017.
As we move through 2018, the one-off effects of the sterling decline will begin to disappear from the annual inflation rate. Food prices have been one area in which rising import costs have had a particularly significant effect. However, recent trade data has shown a plunge in imported food price inflation from 13.3% YoY to 1.5% YoY over the course of five months. As a result food price inflation is likely to slow sharply in 2018 from the four-year high of 4.0% in October 2017. Broader ‘pipeline’ inflation measures, including producer prices and imported prices, both peaked in the first quarter of 2017 implying that CPI should now begin to fall back – as anticipated by the Bank of England. Furthermore, modest wage growth and lingering economic uncertainty, should mean that services inflation remains comparatively subdued. What is not known, however, is the extent to which the recent increase in inflation may have changed inflation psychology within the economy. If there has been a weakening of the low-inflation anchor that has been evident for a number of years, then higher inflation could prove more persistent.
In November 2017, the Monetary Policy Committee raised interest rates for the first time in a decade. Simultaneously, it provided forward guidance that future rate rises would be ’limited’ and ’gradual’. Financial markets are pricing in only one rate increase in 2018. On the basis of the Bank’s inflation forecasts, this may seem like an appropriate policy profile, particularly in the face of ongoing Brexit uncertainty. However, there remain risks. In particular, an exceptionally tight labour market and lower net immigration could trigger an escalation in labour costs. This would clearly test the Bank’s resolve.
Eurozone – steadily higher but below target, ECB in no urgency to hike rates
Headline and core inflation in the eurozone are likely to trend steadily higher during 2018, but still remain below the European Central Bank’s (ECB) inflation target. Although recent data suggest core CPI has remained stubbornly low at 0.9% YoY, there are a number of reasons why it will trend higher in 2018.
Eurozone economic activity has picked up markedly during recent quarters and 2017 as a whole is likely to have seen the fastest annual growth in a decade. Consequently, the labour market has seen significant improvement, with the unemployment rate falling to the lowest level since January 2009. Furthermore, factory capacity utilisation has risen to the highest level since end-2008 (83.8%) and is even higher than that in the US (77.0%). As slack in the eurozone economy diminishes, wages and prices will gradually trend higher. That said, judging by the experience in the US and the UK, the time lags may prove considerable and it may take longer than normal for core inflation to reflect the tightening labour market.
Against the backdrop of higher but still benign inflation, the ECB policy looks set to remain relatively accommodative in 2018, with no rush to hike rates despite stronger activity. That said, if activity continues to be as robust as in 2017, the ECB will face more pressure to end quantitative easing later in 2018 and then to hike rates in 2019.
Janet Mui, CFA is the global economist at Cazenove Capital, the wealth management division of Schroders. Janet is responsible for the formulation and communication of Cazenove’s top-down views. She is a member of the investment committee that oversees strategic and tactical asset allocation at Cazenove. Janet is also the macro spokesperson and a regular commentator at major media outlets including the BBC, Bloomberg and CNBC.
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