Reflation - a cautionary tale
We have been urging caution on the reflation story. Much of the increase in inflation recently has been driven by higher commodity prices and largely contained to headline inflation. The conditions for genuine reflation, of the sort that central banks will choose to act on, are only met when core inflation is judged to be not only moving higher, but moving higher on a sustained basis. Many developed economies are still well-short of this mark.
Source: BLS, Eurostat, MIAC
Source: BLS, Eurostat, MIAC
As if to prove the point, recent inflation data out of the Eurozone showed core inflation dropping from an annual rate of +0.9% in February to +0.7% in March. There may be technical reasons for the blip lower but this result is a useful reminder of the reality that the Eurozone output gap is still large and negative, and persistent increases in core inflation are still some way off. Most importantly, the current unemployment rate of 9.5% is still too some way short of any persistent pressure on wages, the 'lynchpin' of a self-sustaining increase in inflation, according to the President of the European Central Bank, Mario Draghi.
Source: Eurostat, Bloomberg
The good news is that with activity looking to be somewhat stronger this year, spare capacity will be absorbed more quickly. That said, we think European Central Bank (ECB) forecasts for core inflation of 1.1% this year rising to 1.8% in 2019 look a tad optimistic.
Progress towards that forecast will of course be a key determinant of the ECB’s monetary policy stance, and particularly their intentions towards their asset purchase programme (APP). We know the Governing Council is concerned about the financial risks around prolonged aggressive monetary easing, but an early exit in the absence of anything else (fiscal policy) risks derailing what are still only nascent reflationary trends. The current APP is scheduled to conclude at the end of this year.
Towards the end of the year we expect an announcement to extend the programme into 2018, probably with an element of tapering. The risk for the ECB is a premature tightening in conditions that derails the growth still required to close the output gap and get the unemployment rate continuing to move lower.
The reflation story is still playing out best in the United States. That’s because the economy is at full employment and the output gap is effectively closed. But neither is core inflation running away. Indeed, the core personal consumption expenditure deflator (PCE), the Federal Open Market Committee’s (FOMC’s) preferred measure of inflation, is trending higher but at 1.8% is still short of the Committee’s mandated 2% target.
Source: BEA, BLS, Federal Reserve Bank of Cleveland, AMP Capital
The FOMC will therefore continue to tighten, but it will remain gradual. Three hikes in 2017 still seems the most likely outcome, but it will be wages that will provide the most useful gauge of any change in that view. The next wage data comes with the full raft of labour market data due out this weekend.
Meanwhile in China, the reflation picture is largely contained to producer prices, itself largely a function of the recent rebound in commodity prices. While this is good for industrial sector profitability, the economy still suffers significant spare capacity. The recent dip lower in CPI inflation was partly food related and can be expected to reverse somewhat in the next month or two.
The improved activity backdrop certainly helps the reflation story in China, though given still significant excess capacity, we think the economy is still well short of the sustained upward pressure on core inflation a central bank would be concerned about. The People’s Bank of China ( PBoC) has been tightening money conditions since late last year, albeit gradually. This is more directed at financial sector risks, particularly in the housing market. More aggressive tightening risks derailing the reflation story.
The global reflation story remains largely a headline inflation story, at least until output gaps are fully closed and core inflation is rising more sustainably. The recent pick-up in global economic activity will be helpful in closing output gaps more quickly than would have otherwise been the case. That being the case, we see global bond yields continuing to head higher over time, but this will be gradual and there will be pauses for breath along the way.
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