From deflation fret to inflation threat - (not) all about that base
From deflation fret to inflation threat - (not) all about that base
At the start of 2015, deflation fears were prevalent across developed economies as oil prices had more than halved. There were concerns that, against the backdrop of lower trend growth and stagnant wage growth, lower inflation would trigger a delay in purchases and a deflationary spiral. Some observers went as far as to say that, in response to deflation risks, quantitative easing (QE) might need to be restarted in the US, or the next interest rate move should be down in the UK. Headline consumer price index (CPI) dipped into negative territory in the eurozone, UK and the US, adding more weight to the media’s argument. So, why do we think the deflation fret will turn to an inflation threat within a year?
Base effect of oil prices matters
The simple initial reason why inflation will turn around by the end of the year is the base effect. Oil prices troughed in January 2015 and have subsequently rebounded by over 10%. Accordingly, the favourable base effect from earlier declines in the oil price will begin to disappear by the end of the year. To quantify the impact of oil prices on headline CPI in the US, UK and the eurozone, we have modelled the relationship based on the transmission mechanism from oil prices to the CPI energy index and futures-based oil price assumptions.
Our findings show that all other things being equal, the negative impact from lower oil prices will be wiped out by January 2016, adding +0.7%, +0.5% and +0.2% to headline CPI in the US, eurozone and the UK, respectively.
The impact is most apparent in the US, as it is the most directly affected by actual oil price changes to energy index changes. The eurozone also sees a notable impact as it has the largest energy weight within its CPI amongst the three economies. The UK is likely to see the least impact from the change due to less sensitivity in prices and the lower weight of energy in CPI.
But it is not all about that base
Contrary to popular belief, deflation is not the same as negative consumer price inflation. Deflation is the phenomenon in which a persistent decline in prices is one feature of a vicious spiral of falling demand, employment and real incomes.
Do we see widespread evidence of deflation in the US, UK and the eurozone? Not really. Despite low inflation, there was a marked improvement in eurozone retail sales and manufacturing orders in the first quarter, showing no sign of deflation. In the US, while activity was disrupted by temporary factors in the first quarter, the labour market remained buoyant and leading indicators of wage growth are pointing to an appreciable pickup. UK consumption growth remained solid, as evidenced by first quarter GDP, highlighting that a fall in energy prices provides a boost to households’ real income and spending. Hence, we argue that the inflation threat is not only about the waning impact of a favourable base effect, but also about domestically-driven core inflation from sustained macroeconomic improvement.
Solid economic momentum
The US and the UK economies are in a solid expansion phase and have established good economic momentum.
In the US, we will see a rebound in the second quarter as temporary drags on activity dissipate. Recent data on employment, housing and retails sales point to a rebound in growth. In particular, strength in the housing market resulted in continued increases in the price of accommodation. Primary rents and owners’ equivalent rents, which make up 40% of the US core CPI, were up 3.5% year-on-year (YoY) and 2.8% YoY in April. Although there is evidence that the stronger US dollar is depressing the core CPI via lower imported goods prices, it will likely be outweighed by the upside pressure from heavier-weighted services and rental components.
For the UK, the housing market is going from strength to strength as the election uncertainty has passed. Consumer credit is growing at more than twice the rate of the increase in wages, fuelled by car sales and mortgage approvals. As a result of buoyant demand, services prices continue to grow at 2%+ YoY, despite near zero headline inflation. Similar to the US, the robust services and housing sectors will create upside risk to domestically-driven core inflation.
For the eurozone, activity is improving and GDP growth is likely to hit (or even slightly exceed) 1.5% in 2015, compared to 0.8% growth in 2014. Recent activity (in particular in Spain and Italy) has turned more positive, as evidenced by a broad range of industrial, retail and confidence data. The eurozone is now only a step away from achieving more consistent momentum, and we believe an improving trend in credit growth will be supportive. The notable recovery in demand coincides with the European Central Bank’s (ECB) QE programme, and has been reflected in a sharp rebound in inflation expectations.
Wage indicators are pointing north
Labour markets in the US and the UK have tightened considerably over the past few years and unemployment rates have been consistently below the central banks’ estimates. As the unemployment rate approaches the natural rate, domestically-generated inflation will pick up. There is now growing evidence of rising wage pressure in both official wage indicators and survey-based measures.
Hence, we believe there are upside risks to US and UK inflation toward the end of the year and into 2016. In the eurozone, immediate upside risks to core inflation are offset by the persistently high unemployment rate. From our analysis, US headline CPI will be above 2% in January 2016; for the UK and the eurozone, while headline CPI is unlikely to hit 2% before first half of 2016, the trend will clearly be turning up, which will cause inflation expectations to adjust. Hence, we think people could be caught out by inflation surprises towards the end of this year, which will be a complete reversal from what we saw at the start of the year.
Policy and investment implications
For the US, if positive momentum in data continues, it will provide the Fed with enough confidence to start policy normalisation. We see upside risk to wage growth and inflation, which will lead to an interest rate rise as early as September this year, and further increases thereafter. Although we also see upside risk to wage growth and inflation in the UK, the Bank of England will probably follow rather than lead the Fed’s action. The ECB is under the least pressure to begin policy normalisation. While growth in the eurozone has picked up, it is still in its early stages and we expect very loose monetary policy to continue.
As major developed economies have passed the low point of the inflation cycle, it is difficult to see circumstances where bond yields will turn lower. We expect the economic and policy backdrop to remain negative for fixed income. In particular, we believe the bond markets are not currently priced for the perceived upside risk to inflation. In view of this, there is a case for adding inflation protection for portfolios through index-linked gilts. Equities provide inherent protection against inflation. They are better valued in Europe than in the US, with eurozone markets most likely to benefit from improved economic conditions. No markets like the spectre of rising interest rates, and this could cause some short-term turbulence. However, the softly-softly policy approach that is likely to be adopted by the authorities in both the UK and US should ensure that equities can make further headway.
No commentary is complete without a comment on Greece. While the current debacle has dented confidence in financial markets, we do not believe that a Greek exit from the euro would cause lasting damage. Greece is a very small part of the European economy, and the monetary and financial systems of the eurozone, itself, are now far less fragile than they were in the immediate aftermath of the recession. Thus, we believe the risks of economic (and political) contagion are modest. More to the point, we are of the view that it is in the longer-term interest of Greece to leave the common currency. Inevitably, this would be followed by a period of crisis in the Greek economy. However, it would free Greece from trying to survive in a policy system that is inappropriate for its requirements.
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