U.S. Review
That Deflating Feeling Lingers
Falling energy prices and dramatic discounting by retailers pulled the headline inflation figures much lower during December. Falling prices make last month’s retail sales and inventory figures, as well as November’s trade data, much harder to interpret. There is no question real GDP declined substantially during the fourth quarter. Our own estimate calls for a 5.3 percent decline at an annual rate and most forecasts call for a drop somewhere between a five and six percent annual rate.
We have noted previously that we do not believe the economy will endure a sustained problematic period of deflation. We are experiencing deflation, however, with prices of many goods, commodities, and assets falling. Wages and salaries are also being cut, although falling prices may temporarily offset some of this impact. In fact, real hourly earnings have soared in recent months as the headline CPI declined.
The Consumer Price Index fell for the third straight month and the year-over-year growth rate fell to nearly zero. The drop in energy prices and a global recession have combined to push inflation lower.
Pipeline Inflation Has Cooled Off Considerably
Excluding food and energy prices, the core CPI was essentially flat in December. Shelter costs, which are 43 percent of the core CPI, rose just 1.9 percent last year. With housing still declining, we do not look for inflationary pressure here in the coming year.
Inflationary pressures continue to ease further back in the production pipeline. The Producer Price Index declined 1.9 percent in December, its fifth consecutive drop. Though energy prices account for much of the pullback, food prices fell 1.5 percent in December, the largest drop in nearly three years. Prices for fresh vegetables plunged at nearly a 15 percent annual rate and prices for beef and veal, milk and canned fruit and juices all moved lower.
Excluding food and energy items, the PPI rose 0.2 percent and finished the year with a 4.3 percent gain, which was the largest increase since 1988. Core inflation has moderated considerably in recent months, however, and will likely continue to decline in coming months. Prices are falling further back in the production pipeline. Prices for intermediate goods fell 4.2 percent in December and prices for raw materials and crude goods fell 5.3 percent. Both series have fallen for five months in a row. Excluding food and energy items, intermediate and core goods prices are down less but still declined considerably. Prices for core intermediate goods plunged at a 24.6 percent annual rate in the fourth quarter, while prices for core crude goods plummeted at an 82.6 percent pace.
The remarkable declines in energy and commodity prices will make it much more difficult to interpret recent trade figures, retail sales and inventory data. All have plummeted recently but price effects account for much of the drop. Put differently, the volume of imports fell less than the reported record 12 percent drop for November and the volume of retail sales probably did not fall nearly as much as the headline 2.7 percent plunge in retail sales.
While price changes will make it more difficult to interpret recent economic data, it clearly can be done. Inflation-adjusted trade figures show the nation’s trade gap shrinking by $6.1 billion to $39.5 billion. Real retail sales, deflated by the CPI, look like they declined about two percent in December. Consequently, cutbacks in consumer spending were a huge drag on fourth GDP and the recent wide monthly swings in the trade deficit will likely have little effect on the fourth quarter figures. Inventories remain a huge wild card, however. While inventories have declined in recent months, the drop has not kept pace with declines in sales. The inventory/sales ratio has surged in recent months and inventories of imported automobiles have piled up at many major ports.
Global Review
ECB Cuts Rates Yet Again
As widely expected, the European Central Bank cut its main policy rate by 50 bps at its meeting this week. The two-week repo rate now stands at 2.00 percent, matching the low set in 2003-04. As we discuss below, we believe the ECB will need to ease policy even further.
In explaining the decision to cut rates in the post-meeting press conference, ECB President Trichet referenced the “significant slowdown” that is underway in the Euro-zone. “Downturn” would probably be a better word to describe what is transpiring at present in the Euro-zone economy. As shown in the top chart on page 4, the purchasing managers’ indices for the manufacturing and service sectors have plunged into deep recession territory over the past few months. Indeed, “hard” data from November confirm just how weak the Euro-zone economy is at present. Industrial production tumbled nearly eight percent relative to November 2007, exceeding the decline registered during the deep recession of the early 1990s, and retail sales in November fell 1.5 percent on a year-over-year basis. Real GDP data for the Euro-zone have not been released yet, but we project that GDP contracted at an annualized rate of about four percent in the fourth quarter relative to the previous quarter. If realized, it would be the sharpest quarterly drop - by a mile - in real GDP since Euro-zone statistics began to be compiled in 1995.
“Price stability” is the ECB’s sole mandate, and President Trichet also talked about the outlook for inflation as is customary. Trichet said that the risks to price stability over the medium term appeared to be “broadly balanced.” As shown in the middle chart the overall rate of CPI inflation has dropped sharply in recent months, declining to 1.6 percent in December. The stability of the “core” CPI inflation rate over the past year or so relative to the overall inflation rate reflects the sharp rise and subsequent collapse in energy prices over the last year.
In our view, the Euro-zone economy will contract through the first half of this year. On a peak-to-trough basis, we look for real GDP to drop about 2-½ percent, which is a very deep downturn regardless of how one defines recession. As the economic continues to contract, both the overall and core inflation rates should recede further. Indeed, we project that the overall CPI inflation rate will approach zero percent this summer, which will give the ECB scope to cut rates even further. Although the ECB may slow down the pace of easing in the months ahead -- it has slashed rates by 225 bps in only three months – it will need to cut rates further, at least in our view, to help prop up the faltering economy.
As shown in the bottom chart, the euro has depreciated nearly 20 percent on balance since summer as the outlook for the Euro-zone economy has deteriorated markedly. As long as the ECB is in rate-cutting mode, we believe the euro will continue to trend lower versus the dollar. However, as we describe in our recent Monthly Economic Outlook, which is posted at www.wachovia.com/economics, the euro could strengthen again against the greenback later this year as the very sluggish nature of the U.S. economic recovery that we project becomes painfully apparent to investors.
