Euro rate rise expectations overdone

Just over a year ago the ECB cut its main refinancing rate to zero and its deposit rate to -0.4%, having first shifted the latter into negative territory in June 2014. As a result money market rates have also been negative for some time while longer dated  rates only turn positive at a maturity above 3 years. Yet March saw a change in the market view with regard to the ECB’s monetary policy and the possible timing of an interest rate rise, reflecting  both incoming data and  what were perceived as less dovish comments from Frankfurt.

The  euro composite PMI has  certainly continued to strengthen, reaching a six-year high in March,  and points to 0.6% rise in GDP in the first quarter given the past relationship between the two series, with the prospect of even stronger growth in q2. That, in turn, would point to a significant  upward revison to the current consensus growth  forecast for 2017 of 1.7%. Headline inflation also surprised to the upside, reaching 2% in February,  slighly above the ECB’s target.

The market also reacted to President Draghi’s comments that the ‘risks  of deflation have largely disappeared‘. The Governing Council still expects rates to remain ‘at present or lower levels for an extended period’  but Draghi also said that there was a ‘cursory’ discussion  at the March policy meeting about removing the prospect of a further rate cut while also stating that no Council member favoured any additional long term lending to the banking system . The market responded by giving a much higher probability  of a 0.1% rise in the deposit rate  this year and certainly by mid-2018.

The  ECB later let it be known that it felt the reaction excessive relative to the message it was seeking to deliver and rate rise expectations have been pared back somewhat, with a rise of 0.05% priced in by March 2018. The data has also been less suppotive and indeed worrisome for the ECB. The flash estimate for March inflation was much lower than expected, at 1.5%, and if one excludes food and energy the rate fell back to cycle low of 0.7%. Moreover, the modest uptick in credit growth that had been apparent appears to have stalled, with the annual rise in loans to the private sector easing in February, to 2.3%. These figures  impacted the euro, which is now trading back at $1.065 having spiked to over $1.08. The ECB also puts some store on the 5 yr 5 yr inflation swap as a measure of inflation expectations ( albeit less so now than in the past) and that has fallen back below 1.6%.

Some claim the March inflation data owes a lot to the timing of Easter ( in March last year ) and that there will be a seasonal rebound in April, including the core measures.  Unemployment in the euro area is also falling steadily, which might be expected to push up wage inflation ( although the latter has continually disappointed  forecasters) and that view is reflected in ECB projections, which envisage core inflation picking up to average 1.8% in 2019.

On market rates themselves, the level of excess liquidity ensures that short rates do not stray too far from the deposit rate , which is -0.4%. That excess, which tops €1,500bn, is the amount the ECB is pumping into the banking system, via QE and the TLTRO, over and above the liquidity  banks need to meet normal requirements. The Governing Council hopes this will be used to boost bank lending but so far the impact is limited, and one wonders what the ECB would do if credit growth slows in a material way. That issue may not arise but unless core inflation picks up appreciably any rate rise speculation is premature.


The Return of Inflation?

Inflation in the Euro Area has risen sharply of late, with the flash estimate for February at 2%, from 0.6% in November, and is now  at the highest rate in four years. Consumer prices have also picked up momemtum in the other major economies: In the UK the inflation rate has accelerated from 0.9% to 1.8% in four months while in the US the increase is from 1.6% to 2.5% over the same period. As a consequence markets have shifted away from the fear of deflation and now the issue is whether this upturn in prices will prove short-lived or is it the beginning of a more sustained period of inflation, ultimately requiring  a faster policy response than currently priced in to markets. That change is clearest in the US, with the Fed now expected to raise rates again this month.

The more benign interpretation of the inflation trend  is supported by measures of core inflation, which exclude volatile components like Food and Energy. On that definition, the euro inflation rate is at 0.9%, unchanged over the last three months, and so the rise in inflation is due to a rebound in energy prices ( up an annual 9.2% in February) and unprocessed food ( plus 5.2%). These changes partly reflect base effects ( large monthly falls a year ago now dropping out of the annual figure) and the recent increase in global commodity prices, notably crude oil. In the US the Fed’s preferred measure of inflation is the core consumption price deflator, and that is rising at an annual rate of 1.7%, or at an annualised  rate of 1.6% over the past three months, again not flashing red.

What determines core inflation? Profit margins have an impact ( can firms pass on higher import prices in the UK for example) but the main factor is labour costs, and in most countries wage growth remains subdued and is much lower relative to unemployment than in the past. Why this is the case is the subject of much debate but in the absence of a pronounced pick up in wage inflation it is difficult to see price inflation accelerating for a prolonged period.

Headline inflation is what matters to consumers, of course, and the recent rise will dampen real incomes and  probably reduce real consumption and hence GDP growth. A 2% inflation rate is therefore  worse for the economy  than a 1% rate, yet Central Bankers have argued the opposite, as most use a 2% inflation figure as their definition of stable prices. How this became conventional wisdom is hard to fathom ( prices rise by 22% in a decade and just shy of 50% in 20 years, hardly a good measure of stability) while the fear of deflation is strong, even though Japan, the land of falling prices, has not really suffered in terms of its real GDP growth per head. Inflation at 2% may be fine with wage growth of 4%, as was the case , but not if wage growth is 2% or below, as appears to be the ‘new normal’. There is not much central bankers can do in the short term to influence energy or food prices, of course, but higher headline inflation will dampen real spending in the absence of an acceleration in nominal wage growth.