• Passé. The deep global recession in conjunction with the free fall in oil prices last year sent inflation plunging and has even seen inflation rates slide into negative territory. The deflationary intermezzo is, however, now over (pages 3-5 & 6-8).

  • EMU. As early as the turn of this year, consumer price inflation should spike again to 1%. But the sole reasons for this are the again rising oil price and the reversal of the once so beneficial base effect of the oil price decline. This does not, however, translate into inflationary pressure!

  • Relief. The unprecedented EMU-wide output gap or the massive excess capacity, respectively, as well as the firmer EUR, mean that the underlying inflation trend will continue to moderate to almost zero in the coming year; in Germany, we expect core inflation of only ½%.

  • US. We expect a similar development in the US, despite the USD weakness. As early as December, the headline inflation rate should spike to 2.3% and rise even further thereafter. Core inflation, in contrast, should moderate to only 0.6% by fall next year.

  • Central banks. The ECB and the Fed are, therefore, in no rush to turn the interest rate screws – even though inflation fears will likely grip markets from time to time. But they will prove to be short-lived.

  • Further topics:

    – Weekly Comment: The central banks' next challenge (page 2).

    – Norway’s central bank decouples (page 9).

    – Data outlook: Business climate continues to improve across EMU; US consumers remain skeptical (page 11).

    – Market outlook: Breather for EUR-USD; government bonds remain well supported (page 19).


Central Banks' next challenge

Central bankers have been especially loquacious in recent days. Officials from the major developed regions’ central banks already faced a quite demanding task in terms of communicating their current thinking on the exit strategy. As the rally in risky assets since March has reignited talk of asset price bubbles, investors are especially sensitive to any signals that central banks might prepare to tighten monetary policy sooner rather than later in order to deflate or puncture the bubble at an early stage. Both the ECB and the Fed, meanwhile, have to balance the need to avoid the danger of future bubbles with the immediate concern that the global recovery is still tentative and fragile, and might be jeopardized by a premature tightening in the major economies. This calls for a very careful fine-tuning of rhetoric: sounding too dovish might encourage investors to take excessive risks, but sounding too hawkish might scare markets too abruptly and trigger a sell-off in equities that could in turn undermine confidence and weaken balance sheets.

As if this were not enough of a challenge, central bankers need to keep a keen eye on currency markets. The rally in risky assets has coincided with a significant weakening of the USD, both against the EUR and in trade-weighted terms. The weakening of the USD has been gradual and orderly, and most economists see it as in line with fundamentals, given the need for the US to rebalance its external accounts. However, the EUR has borne the brunt of the adjustment, and the eurozone’s economy therefore faces an additional risk to its incipient recovery. The IMF encapsulated the problem in a short paper released in preparation for the latest G-20 meeting – it argued that the USD is if anything still somewhat overvalued, but also that the EUR has strengthened excessively.

As mentioned above, the weakening of the dollar has been orderly and in line with what fundamentals would dictate. As such, one could argue that it should not be attracting as much attention. The reason it does, of course, is the fear that the depreciation might suddenly accelerate and get out of control. This is a scenario that scares most policymakers around the globe: the US would find it difficult to finance its growing public debt, and would face fast-rising interest rates; the eurozone would face such a drastic appreciation of its exchange rate that the recovery would probably collapse like a house of cards; and all major central banks and sovereign wealth funds which hold the largest part of their reserves in USD-assets would see their value collapse. If the US can no longer say to the rest of the world that the dollar is “our currency, but your problem”, we have now moved to a situation where global policymakers can say with one voice that the USD is “our problem”.

This common problem feature takes some pressure off the US, which can feel that it is not fighting this battle alone, and therefore the risks of things going badly wrong are limited. Indeed, comments from Fed officials continue to strike a very dovish tone. Chairman Bernanke a few days ago reiterated that the recovery remains extremely fragile, in terms that suggest that the Fed is unlikely to change soon the language of the FOMC statement where it indicates that rates are likely to stay exceptionally low for an extended period. Meanwhile, his colleagues Plosser and Fisher have played down concerns that the weak dollar might fuel inflation pressures. The overall impression is that the Fed for now is taking a relatively sanguine view of the FX risk, and focuses on the need to allow the recovery to gain traction, so that employment losses can be halted and eventually reversed.

Eurozone policymakers find themselves helpless. Mr. Juncker noted that the strong euro is a consequence of the imbalances of the US and China – and indeed, considering the fact that the eurozone’s external position is broadly balanced, it does appear that the euro is an innocent bystander caught in the crossfire of two much bigger and powerful rivals. ECB officials sound like a broken record as they repeat over and over again that they take note of how Fed and US Treasury consider a strong dollar to be in the interest of the US.

The ECB is therefore also focusing on domestic priorities, and has taken a slightly more hawkish tone than the Fed – indeed, President Trichet has given every indication that at the December press conference the ECB will start outlining its exit strategy. It will be a very gradual exit, starting with the withdrawal of excess liquidity – we still expect the refi rate to remain on hold throughout next year. But the ECB will nonetheless need to be wary of the risk that giving the markets too hawkish a signal might propel the euro to new highs.