Weak inflation and uneven growth

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Inflation, one of the key economic indicators under the scrutiny of world central banks, has continued to struggle in the face of falling energy prices. In the week commencing 19 October 2015, the consumer price inflation (CPI) prints for Germany, the UK and the US, as well as the print for the eurozone aggregate index, have all told a similar story: the rate of headline inflation is neutral to falling, while core inflation is rising modestly. At the same time, the major economies continued to exhibit uneven growth.

The results of the monthly survey of over two hundred German analysts and investors by think tank ZEW disappointed. Its index of economic sentiment deteriorated to a 12-month low of 1.9 in October from 12.1 in September, while its current conditions index fell to 55.2 from 67.5 in September. Although generally the ZEW survey indicators are considered as leading, it is unlikely that these results alone are pointing to a significant downside risk as the German economy remains well supported by domestic demand and eurozone recovery.

The UK’s unemployment rate is now at its pre-recession levels: it fell to 5.4% in the three months leading up to August, down from 5.5% in the three months leading up to July. As a further sign of strength in the labour markets, the total earnings of workers rose by 3% YoY for the three months to August, although this was lower than the consensus forecast of 3.1%. On a six-month moving average basis, the unemployment dynamics in the UK are some of the best among the developed nations, while those of Canada are some of the worst. In the first half of this year, falling energy prices forced Canada’s economy, which depends significantly on oil exports, into a moderate recession. Although widely expected to rebound, the recession caused the September unemployment to edge up to 7.1%, the second increase in a row.

Like the CPI, the US headline Producer Price Index (PPI), a measure of prices received by domestic producers for their outputs either on the domestic or foreign market, was pushed lower by petroleum products. But unlike the CPI, both the headline and core PPI printed well below forecasts. Additional potential headwind for inflation could emanate from the industrial capacity utilisation, which continued its declining trend of the last twelve months and fell to 77.5% in September from 77.8% in August. The US Treasury and Treasury Inflation-Protected Securities (TIPS) markets reacted somewhat conservatively: both five- and 10-year US breakeven inflation (BEI) rates contracted by about five basis points. BEI is a gauge of market participants’ perception of inflation expectations and risks.

It is interesting to consider the recent US inflation trends in the broader context of the analysis provided by the Inflation Project at the Federal Reserve Bank of Atlanta. Researchers at the regional central bank have grouped the components of the monthly CPI into “sticky” and “flexible” aggregates. The components whose price changes occur on average once every four months or less are deemed flexible. Otherwise they are classified as sticky. As shown in exhibit 1 below, the year-over-year change in flexible CPI is at a post-crisis low. The drop and continued weakness in flexible CPI can clearly be attributed to energy prices. More interesting is the evolution of the core flexible CPI, which is defined as flexible CPI less food and energy components. This measure has been on a steady downward trend for the last four years and has teetered on the brink of deflation this year, suggesting that not all weakness in inflation should be written off to falling energy prices.

Exhibit 1: Percentage change in CPI components (year-on-year)


Source: Federal Reserve Bank of Atlanta, as of 16 October 2015

Further signs of weakness in inflation can be seen in exhibit 2 below, which shows the five-year deflation probability estimated from the TIPS and US Treasury nominal bond markets. The likelihood of deflation has been negligible for nearly the last two years, but has increased sharply since September and reached 6% on 14 October.

Exhibit 2: Deflation probabilities


Source: Federal Reserve Bank of Atlanta, as of 16 October 2015

It is difficult to conclude with certainty whether the evidence provided by the recent widely followed inflation indices as well as by the less traditional sticky CPI and probability of deflation measures points in the direction of persistent long-term weakness. However, this uncertainty will surely provide some extra ammunition to those Federal Reserve (Fed) policymakers who are leaning towards pushing the increase in short-term interest rates into 2016.

BNP Paribas Asset Management is the source for all data in this document as at end 16/10/15, unless otherwise specified.

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