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Friday Notes

Inflation: No all−clear yet

Fri, Aug 22 2008, 13:52 GMT
by HVB Group Global Markets Research

HVB Group

• Relief. The consolidation in commodity prices, first and foremost crude oil, is bringing relief on the inflation front. The direct effects should push the August inflation numbers in the eurozone, scheduled for release at the end of next week, below the recent highs.
• Pressure. It is, however, definitely too soon to sound the all-clear. Even though inflation should now have peaked, commodity prices remain high, suggesting further limited pass-through effects in the coming months (pages 7-9). In the US, the core rate will likely still even edge slightly higher (pages 4-6).
• Risk. We think it will be next spring before we see noticeable relief for inflation. Until then, the annual rate will probably moderate only gradually. Above all in the eurozone, wage demands should, therefore, remain very high, thereby eliciting continuing warnings from the ECB on second-round effects.
• Dampener. Support for the inflation watch-dogs is coming from cyclical downward forces. The US labor market has been weakening for some time now, in the eurozone the trend reversal appears to have been completed, and even the strong labor market upswing in Germany will probably run out of steam soon (pages 10-12), thereby reducing the probability of excessive wage settlements.
• Further topics:
  – Weekly Comment: Just a breather (page 2).
  – Data outlook: EMU: Renewed decline in the business climate; US: House prices continue to fall (page 13).
  – Market outlook: EUR/USD stabilizes (page 23).

Just a breather

Eurozone PMI data confirmed that the eurozone is flirting with a technical recession. Our baseline forecast suggests that this embarrassment should be narrowly avoided, but the pain on the real economy cannot be, and the ECB will still need to lower its growth projections next month. With the correction in commodity prices already starting to cool inflationary pressures, it is increasingly evident that the next rate move will be down - even though ECB rhetoric indicates that this is unlikely to happen before Q2 next year. Rate cuts should materialize sooner in the UK, where uncertainty on the timing and magnitude of monetary easing is, however, much higher. The USD rally has taken a breather, as renewed concerns on Fannie and Freddie have come as a painful reminder of the unresolved fragilities in the housing and financial sector; oil prices have recouped some of their recent losses, hand in hand with the USD movement. After the sharp turn in sentiment of the last few weeks, markets are taking a step back to reassess the relative value bet on US versus eurozone (and much of the rest the world) as well as the directional bet on whether the global economy is headed for a soft landing or a belated crash. I would still bet on a soft landing, and on a renewed downward trend in EUR/USD and oil prices. US dollar and oil had bolted too fast and a consolidation was in order - but this is just a breather before the long-distance challenge. This weekend the markets will look to Jackson Hole for guidance from US policymakers. I expect the key message to remain the same: hawkish but unhurried on monetary policy, more emphasis and urgency on targeted measures to support housing and finance, and concerned recognition of the fact that the economic outlook remains extremely difficult to decipher.

August PMIs dropped further in Germany and France, undershooting market expectations, but the Eurozone PMIs stabilized, a positive and puzzling surprise suggesting that either Spain or/and Italy have rebounded, or the Eurozone is really more than the sum of the parts… French manufacturing was particularly disappointing (a 2 percentage point drop), confirming that France is joining Italy and Spain in a slump. Germany’s manufacturing PMI dropped below the critical 50 threshold with the fourth decline in five months; together with a sharp drop in the services index, this signals a very high probability that the Ifo will fall further next week. Overall, the data confirm the picture of an inexorable slowdown in all the main Eurozone countries, as consumers batten down the hatches and foreign demand weakens, leading firms to scale back investment plans. Our proprietary EMU composite indicator points to +0.1% growth in Q3, which would spare us the embarrassment of a technical recession but would still force the ECB to lower its growth forecasts next month. Moreover, this +0.1% baseline is still uncomfortably close to a dip in negative territory.

Input prices decelerated markedly, confirming that the correction in commodity prices is cooling inflationary pressures before any meaningful second round effects have had a chance to show up in core inflation. ECB officials meanwhile are ratcheting up the anti-inflation rhetoric, a strong signal that they will not lower their guard until they are confident that the commodity price correction is sustained and that price pressures already in the pipelines will not feed through into the core rate. I believe this is the right strategy, although I remain concerned that the insistent denials that slowing growth will help cool inflation may harm the ECB’s credibility.
Today’s data seem to confirm that swings in commodity prices tend to feed through much more quickly into inflation and inflation expectations than into activity indicators. If that is the case, we should see a significant decline in headline inflation accompanied by a persistent further weakening of GDP growth before lower energy and food prices start cushioning the fall and preparing the ground for a recovery. The next ECB move will have to be a cut. On current data and ECB rhetoric trend, Q2 next year still seems the best bet.
The Bank of England has provided a much more pragmatic, balanced and candid assessment of the balance of risks to growth and inflation, both in the August MPC minutes released yesterday and in the latest inflation report. The BOE has warned that short-term risks to both inflation and growth have worsened, with producer prices on an upswing, sharp rises in utility tariffs in the pipeline, and a rapid deterioration in housing and credit conditions. The Bank has also shown it takes inflation risks very seriously, with one MPC member actually voting for an immediate rate hike (ECB-style) to preempt second round effects. At the same time, however, the BOE seems more confident that the weakening labor market should continue to keep wage pressures at bay, and has openly recognized the risk that a worse-than-forecast plunge in economic activity might push inflation well below target in the medium term. Unusual volatility in some data (see the bounce in July retail sales) complicates the policy assessment further, but in the UK as well the next rate move will have to be a cut, most likely in January.

Uncertainty on the timing and magnitude of UK rate moves is, I believe, much higher than in the eurozone. The policy rate starts at a higher level, and the economy is in much more desperate need of help. Should inflation decline faster than expected, or the labor market deteriorate at an accelerating pace, we might see a faster and deeper easing cycle than is currently priced in, and in that scenario the downside for sterling would widen significantly even after the recent losses.

The USD is taking a breather, as the less gloomy eurozone PMI releases coincide with heightening concerns on the fate of Fannie and Freddie. The GSE’s (Government Sponsored Enterprises) woes underscore the two critical vulnerabilities of the US economic outlook: a housing sector that has not yet touched bottom, and a beleaguered financial sector. The US outlook remains particularly uncertain, and it is not surprising that after a sharp repricing of the US vs. eurozone over the last couple of weeks, the market is now stepping back to reassess this relative value trade. I remain of the view that EUR/USD is likely to consolidate just below 1.50 before making another push lower, a move for which the upcoming presidential election could provide the decisive impulse. Oil prices have taken back some of their recent losses, again moving hand in hand with the swing in the USD. I had warned last week that, after the sudden turning point in market sentiment on the USD and on commodities, we were likely to see renewed volatility rather than a smooth adjustment, and I still believe that the downward trend in EUR/USD and oil prices will prevail in the coming months.

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Published on  Fri, Aug 22 2008, 13:58 GMT