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Fed joining the inflation−fighter camp

Fri, Jun 13 2008, 12:15 GMT
by HVB Group Global Markets Research

UniCredit Group

• US. The focus of monetary policy changed within the space of a few weeks from recession fears to inflation concerns. The numbers seem to support the new Fed stance: Instead of contracting as feared, the US economy most probably stagnated this spring. However, much more than stabilization at a low level should not be expected for coming quarters either (pages 5-8).

• Patience. It will, therefore, take a few more months before the Fed switches from its now neutral stance to a tightening bias, especially since medium-term inflation expectations appear to be still firmly anchored (cf. chart). And we think it will be spring 2009 before we see the actual start of a tightening cycle, which the markets are already pricing in for this autumn.

• Divergence. At that time, however, monetary policy on both sides of the Atlantic will diverge again, since the US economy should stage a recovery, while growth in the eurozone will remain well below potential. For that reason, the ECB will ultimately have no alternative but to cut interest rates starting in spring of next year.

• Trend. Alongside the Fed, CEE central banks are also following the ECB in adopting a pronounced anti-inflation stance. Turkey has already taken the initiative; Poland and Hungary will follow suit (pages 9-10).

• Further topics:
  

  – Weekly Comment: Great expectations (page 2).

  – Germany: Inflation postpones recovery in consumption (page 11).

  – Italy’s new fiscal policy: A first assessment (page 13).

  – Data outlook: ZEW indicator to continue to fall; Swiss central bank to tighten next week; US producer prices to soar again (page 15).

  – Market outlook: EUR and bonds to remain under pressure (p. 22).

Great expectations

Central bankers and markets have shifted their focus squarely onto inflation risks. The ECB is about to turn words into actions; Fed officials came out in force to stress their determination to keep inflation expectations in check; the Bank of England has adopted a more hawkish stance and the Bank of Canada yesterday declined to validate market expectations of a rate cut. Financial markets are now pricing in a rather aggressive tightening in the eurozone, US and UK. Are central banks’ concerns justified? And will they act as aggressively as markets seem to expect? I believe actual monetary tightening at this juncture would be premature and risky, and that central banks are further away from tightening cycles than markets are pricing in, so that expectations of rate hikes are exaggerated. I also maintain that the ECB’s communication strategy has proved disappointing at a very delicate and important juncture. I do however have sympathy with the central banks’ underlying concerns. Should commodity prices continue to rise, inflation expectations might eventually become unanchored – but this would be only one of several very serious problems: a global recession would likely follow. This would be a very ugly scenario with no winners – it is hard to see how even commodity exporters could escape unscathed – and virtually all asset classes would suffer. I do not think this will come to pass, and central banks are right in talking tough and striving to keep expectations anchored while we wait for commodity prices to at least decelerate. The real danger however is that, should the commodity bull run continue unfettered, the matter may well be out of their hands.

The emphasis on inflation expectations is not new. Both the Fed and the ECB have long emphasized the importance of keeping inflation expectations anchored. Having anchored inflation expectations at a very low level is considered as one of the greatest achievements of monetary policy in the last few decades, and is often cited as a key contributor to the “great moderation” and “great stabilization”, the secular decline in inflation rates and in inflation, and output volatility in industrialized economies. The Fed in particular has emphasized that low and stable inflation expectations allow central banks the leeway to respond to negative output shocks with decisive monetary easing: as long as consumers and producers maintain faith in the central bank’s ability to keep inflation under control, monetary easing can cushion the blow to growth without causing inflation. Central bankers have been equally careful to stress that the stability of inflation expectations cannot be taken for granted, it must be constantly monitored and supported by a credible monetary policy. They are also well aware that we have at best an imperfect understanding of what shapes inflation expectations and of how they in turn impact inflation. Boston Fed President Rosengren recently articulated this clearly: “… how inflation expectations are set remains an issue that economists are only beginning to understand, and an area of considerable disagreement.”

The stability of inflation expectations in the face of a sustained rise in commodity prices could in fact seem too good to be true. And since other “too good to be true” stories have unraveled in the last twelve months, central bankers are right in taking seriously the risk that inflation expectations might become unanchored. The more difficult and controversial question is how serious this tail risk is, and how much insurance central banks should “buy” against it, keeping in mind the insurance cost in terms of heightened downside risks to growth. What is happening to inflation expectations? In Europe, the EC Consumer Survey shows that inflation expectations have remained stable for quite some time (measured as the difference between the percentage of consumers expecting a rise in prices and those expecting stable or declining prices, cf. chart).

In the US, survey measures of short term (one year) inflation expectations have moved up markedly. This however seems to reflect largely the rise in energy and food price inflation; medium-term expectations, in contrast, have remained broadly stable, indicating that consumers still expect the commodity shock to fade (cf. chart next page).

A similar difference between short-term and medium-term inflation expectations is evident in market-implied measures of inflation expectations. For example, 5Y5Y forward inflation swap measures have increased only moderately in both the eurozone and the US, notwithstanding the sharp rise in oil prices. Not all is well, however: a rise in inflation expectations and in the inflation risk premium is clearly visible in breakevens on European and US bonds. The chart below illustrates this with US, UK and Italian bonds. Note that the UK example clearly highlights the risks of a weakening in central bank credibility, in my view: there was a first significant upward jump around the time of the Northern Rock fiasco, which has then been followed by a more significant rise than in break-evens than in either the US or the eurozone.

The bottom line seems to be that the sustained rise in commodity prices has so far pushed up short-term inflation expectations in an almost mechanical and predictable way, but has not had a measurable impact on longer-term inflation expectations: consumers and producers still expect the commodity shock to fade and maintain their confidence in central banks’ ability to deliver price stability.

With stable and well-anchored medium-term inflation expectations, core inflation also remains well-behaved in the eurozone, the US and the UK (cf. chart next column).

This looks like reassuring prima facie evidence that second round effects are certainly not a major and widespread problem at this stage. In the eurozone, the ECB has hinted that some second round effects have begun to materialize in the services sector; since services account for about 70% of eurozone value added, this might be an important concern. On closer inspection, however, these seem to be limited to subsectors that are directly and heavily impacted by higher fuel and food prices, such as air and sea transport and hotels and restaurants. Overall services inflation in the EMU actually appears to be on a downward trend, consistent with the weakening in services activity indicators since mid-2007. Core goods inflation also seems to be on a downward trend (cf. chart).

There has been a noticeable acceleration in wages and unit labor costs (ULCs) over the last twelve months, and the ECB has underscored its concern that a widespread acceleration in wage dynamics could trigger second round effects. I fully agree with the ECB’s reiterated calls for responsible wagesetting behavior consistent with productivity growth. I also agree that greater labor market flexibility is desirable, including the elimination of wage indexation mechanisms that still exist in some countries and sectors. I am not overly concerned, however, by wage developments to date. The rise in ULCs we have seen so far seems in line with normal developments at this stage of the cycle, with slowing output growth and employment sticky at high levels being reflected in slowing productivity. Our analysis shows that the relationship between ULCs and inflation is quite unstable, whereas the output gap is a much better predictor of inflation. Our estimates suggest that the output gap is broadly zero at the moment, and should soon turn negative with the growth slowdown which is already underway. The cooling impact of slower activity and a weaker labor market on wage dynamics is already evident in the US, where the growth slowdown is already in full swing (cf. chart, where the unemployment gap is measured as a deviation of the unemployment rate from NAIRU).

From the evidence reviewed above, I would draw the following preliminary conclusions:

– Inflation expectations in both the US and the eurozone are still well-anchored, indicating that consumers and producers still have strong confidence in central banks’ ability to deliver price stability and believe the commodity price shock will fade without lasting consequences.

– There is so far very little evidence of second round effects. Moreover, the growth slowdown which is already in full swing in the US and getting underway in the eurozone should keep a lid on wage dynamics, and weaker domestic demand should limit firms’ pricing power, minimizing the risk of more broad-based price pressures.

– Commodities are the wild card, and central banks are right in exercising vigilance. The sustained rise in commodity prices has not affected core inflation, but it has been reflected in higher short-term inflation expectations and a higher inflation risk premium in bond markets. The exponential rise in oil prices, in particular, has already lasted far longer than most people expected. If commodity prices do not stabilize, the risk that they will eventually trigger an upward movement in longer-term inflation expectations clearly cannot be discounted, and in this respect central banks are right in reiterating their commitment to price stability.

– The cards are still stacked against inflation, however, given the bearish growth outlook. Considering also the persistent uncertainty on the fragility of the financial sector, therefore, an actual tightening of monetary policy seems premature at this stage.

– I believe the Fed is not in a hurry to hike rates. The recent shift in emphasis is a an important signal that the Fed sees reassuring signs in the resilience of the US economy, and is also helpful to support the USD against the prospect of an ECB rate hike. A tightening of US monetary policy at this juncture however seems unlikely.

– The ECB has all but confirmed it will hike next month, but has now also cautioned that it has not already decided to deliver the series of rate hikes priced in by the market. It will be hard at this stage to persuade the market that there is only one fine-tuning hike ahead, but the partial back-pedaling suggests the ECB also realizes that any tightening should be done with caution.

There is one uncomfortable conclusion that emerges from all this, however. The heightened anti-inflation rhetoric of major central banks is largely hinged on the fear that commodity prices might fail to stabilize, and that inflation expectations might eventually become unanchored. But if the rise in commodity prices we are witnessing really is fully driven by growth in emerging markets and poor supply fundamentals (as claimed by many), and it does not stop, then the ensuing rise in inflation expectations will be only one of several very serious problems. The process of demand "destruction" which appears to have already begun would accelerate, fuelled by higher energy prices and higher interest rates, and could quickly trigger a global recession. This would be a very ugly scenario with no winners – it is hard to see how even commodity exporters could escape unscathed – and virtually all asset classes would suffer. I do not think this will come to pass, and central banks are right in talking tough and striving to keep expectations anchored while we wait for commodity prices to at least decelerate. The real danger however is that should the commodity bull run continue unfettered, the matter may well be out of their hands.

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Published on  Fri, Jun 13 2008, 12:29 GMT