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.

Irish Q2 GDP; Deflation re-emerges.

Irish real  GDP contracted in the first quarter, by 2.1%, and the latest CSO data shows a modest  0.6% recovery in q2. Nominal GDP fell however, by 1.0%, which followed a 5.6% decline in the first quarter. Consequently, the consensus forecast for nominal GDP in 2016 is probably too high as indeed are forecasts for real growth of 4.9% and the coming weeks are likely to see some downward revisions.

Consumer spending was weak in the second quarter, declining by 0.5% in volume terms, and  business spending on machinery and equipment also fell, by over 10%. Exports, too, declined, albeit marginally. This broad weakness was offset by a 5% rise in construction and a surge in spending on R&D ( including patents and licences) which is classed under ‘intangibles’ . The latter component is extraordinarily volatile and actually more than doubled in the quarter alone ( +113%) , and as such  was the main factor behind the 39% rise in total investment spending. These intangibles are largely multinational and often purchased from parent companies abroad, so imports also rose strongly in the quarter, by 12%. There was also a postive stock build, adding 1.3% to GDP, although the sum of the components imply that real GDP actually fell, with a large statistical adjustment accounting for the positive growth figure.

On an annual basis real growth in q2 emerged at 4%, and the first quarter figure was revised up to 3.9% so giving an average for the half year also around 4%. Real GDP rose by 5.5% in the final two quarters of 2015 and that  base effect implies that annual growth may slow substantially in the second half of 2016, with the average for the year likely to be well below the 4.9% assumed by the Government.

Similarly, the nominal level of GDP in 2016 is also likely to be lower than anticipated, largely because export prices are falling . Consequently, nominal GDP only grew by an annual 0.5% in q2 , which followed a 1.5% rise in q1. On that basis nominal GDP may be largely unchanged in 2016 or indeed may even decline, with implications for the debt and deficit ratios.

Overall, a mixed bag. The real economy avoided recession , which was a risk given falls in retail sales and industrial production in q2, but deflation has re-emerged, via export prices.

Falling Prices versus Deflation

Consumer prices in Ireland fell by 0.3% in the year to December, providing a welcome boost to the real income of Irish households. Prices also fell across the euro area, declining by an average 0.2%  Good news then, one might think, so consumers may well be puzzled by the reaction of policy makers, with the ECB announcing its intention to take further action in order to raise prices and boost the  euro  inflation rate  towards 2% per annum, citing the risk of deflation as the catalyst for the move. Why are falling prices deemed a bad thing when central banks have spent most of the last fifty years worrying about the problems caused by rising prices?

Not everyone is convinced that deflation currently exists in Europe because the concept involves the notion of a persistent fall in prices rather than a short term period of negative inflation. This in turn depends on what is causing prices to fall – is it in response to a supply shock such as a rise in oil production (which some economists have termed ‘good deflation’) or as a consequence of falling demand (‘bad deflation’.) Looking at the Irish CPI it is clear that a key factor is the sharp decline in global commodity  prices , which started in earnest over the summer months and has resulted in declining food prices ( down 2.7% in the year to December) and energy costs ( down 5.5%). The latter has further to fall and largely for that reason most forecasts  envisage the annual inflation rate staying negative in Ireland and across the euro area for at least the first half of 2015.

If one excludes energy and unprocessed food Irish prices rose, albeit by a modest 0.5%, and this points to the case  against the prospect of deflation – energy prices will not fall for ever and so the deflationary impact on the CPI will eventually fade. Goods prices account for less than  half of the Irish CPI (45%) and the price of services is still rising ( up 1.7% or 2.8% excluding mortgages) so a sustained fall in  the CPI would probably in turn require a prolonged and heavy  fall in wages. Ireland has seen a  modest fall in wages on one measure (the micro data at industry level) but not on another (the aggregate wage figure used in the national accounts)  while wage growth is positive on average across the euro area.

The performance of  euro equity markets would also suggest that deflation is not a base case,  and the ECB concurs, although stressing that the risks have risen. Modern experience of deflation is limited to Japan but prices also fell steadily during the Great Depression in the US and elsewhere, which has contributed to the association of falling prices with very negative developments in the real economy. The argument partly focuses on expectations , with households and firms postponing consumption and investment in anticipation of lower prices  next year. Deflation will also  affect real interest rates as nominal rates for most borrowers are bounded at or close to zero, implying real rates will rise if the price level falls. This would increase savings and reduce consumption and investment.Similarly, if nominal prices and incomes fall the real burden of household and government debt rises, a particular concern given the current scale of outstanding debt.

The expectations element in deflation has made central banks, including the ECB, very keen to monitor the private sector’s view on future prices. That can be hard to gauge (surveys tend to be strongly influenced by the recent trend) which makes market-based measures ( inflation swaps or derived from nominal versus real bond  yields)  popular as they can be monitored in real time. On that basis the US market is expecting inflation  to average around 1.5% a year for rhe next decade while the ECB’s favourite measure suggests euro investors expect inflation in 5-years time to also average around 1.5% over the following 5 years.

Evidence, then, that inflation is expected to be low and certainly below  the 2% level many central banks view as optimal, but not that there is a widespread belief that inflation will stay negative for a long time. This low inflation outlook is not a scenario which implies strong growth in nominal wages but certainly one in which short periods of falling prices is a positive rather than a negative.

 

ECB -where to from here?

The ECB’s mandate is to deliver price stability, which the Bank itself initially defined as an annual inflation rate below 2%. Clearly there was no thought given to the risks of deflation with such an asymmetric target and the definition was subsequently tweaked to the current ‘below but close to 2%’. Euro area inflation fell below 2% in early 2013 and below 1% a year ago, with the latest ECB staff forecast projecting very low inflation for at least another two years. Moreover , the forecast was predicated on oil prices averaging $86 a barrel next year , which now looks high given that Brent is currently trading under $70.

There are ‘long and variable’ time lags with monetary policy, so one could argue that the current low inflation rate (the flash figure for November was 0.3%) reflects policy decisions made some time ago-remember the ECB actually tightened policy in 2011. Against that backdrop the recent press conference by ECB President Draghi was remarkable in many ways, not least because he had promised ‘immediate action’ on inflation in a speech in the latter part of November.

In the event the only change of note was in the language surrounding an expansion of the ECB’s balance sheet, which had been  ‘expected‘ to reach the level seen in early 2012 but now measures are ‘intended’ to achieve that level. That would entail an increase of about €1,000bn and clearly there is no agreement within the ECB to promote that as a target. Indeed, Draghi stated that there was not unanimity among the 6-member Executive Board on the announced change in wording, limited as it was.

Draghi had previously played down disagreements within the Governing Council but here seemed willing to place them out in the open, emphasising at one point that previous decisions had been taken  by majority. The obvious divisions  on further policy action made for an uncomfortable conference, however, with Draghi having to again indicate the need for more time to assess the situation despite more forecast downgrades and the blatant contradiction between that  approach and his earlier promise of ‘immediate action’

The upshot is that the Governing Council will reassess the situation ‘early next year’  including the size of the balance sheet. That will be affected by the existing bond buying programme (albeit the figure to date is just €22.5bn) and the outcome of the second targeted long term loan operation (the TLTRO). The latter saw a low uptake for the first tranche (€82bn) and there is a wide range of expectations with regard to the one upcoming, while there will be some offsetting downward pressure on the balance sheet via repayment of previous long term lending to the banks.

The euro rallied during the conference, which was attributed to disappointment about a  QE announcement, although that remains  the market’s general expectation. For others, including this writer, it remains less than a certainty that the ECB will eventually buy sovereign debt, and if it does it is not at all clear how much of an impact it will have on economic activity and inflation, leaving aside the impact it has already had on asset prices. A lot of uncertainty then, and one wonders if the next few months will see further resignations from the ECB Council given the fundamental disagreements on the next steps for monetary policy.