Is central bank confidence that inflation will return to 2% justified?
By David Absolon, Investment Director at Heartwood Investment Management
Headline inflation measures across developed and emerging economies have disappointed consensus expectations over the last few months. Global central banks, however, remain on message that energy price-effects will be transitory and inflation will return to a trend over the longer term. These reassurances are not being believed by the market and there are growing fears that deflation is becoming an entrenched feature of the global economy. In the US, Europe and the UK, the implied breakeven inflation rates on 5- year inflation-linked securities have fallen steeply since July, and stand well below most central banks' targets of 2%.
Some economists argue that lower oil and other commodity prices are less a windfall gain for Western consumers and more a significant deflationary pressure worldwide. The renewed slide in the oil price has intensified disinflationary pressures in recent months, and we accept that deflation risks have increased which might prompt a more severe economic slowdown. But in our view, this scenario continues to remain a small probability and we maintain our core conviction that developed economies, and in particular the US, should see a return to a more normalised environment, albeit subject to a lower growth and inflation outlook than relative to history.
Over the short-term, there are two trends that should provide more comfort that developed economies can withstand global disinflationary forces. First, we would need to see evidence of a stable oil price. This may seem an elusive prospect after last week's price gyrations (Brent crude oil fell 6%), but there are signs that the equilibrium between supply and demand is starting to adjust. US production levels have been cut as expectations of rising global demand have been reported. High profile energy companies have also announced cutbacks – for example, Royal Dutch Shell has announced it would stop drilling for oil off Alaska's Arctic coast – at the same time as OPEC has warned of a sharp decline of investment, potentially leading to higher prices.
Second, following its meaningful appreciation since July 2014 (17.5% on a trade-weighted basis), we also need to see a stable US dollar as it retains its preeminent role in global trade and commodities. Inevitably, a strong dollar has significantly lowered US import costs, forcing US domestic producers to lower their prices and reduce margins to remain competitive. On a longer-term basis, and in this maelstrom of 'currency wars', the reduced competitiveness of the US economy should naturally widen the US trade further reinforced by China's reduction of US dollar holdings in defence of the renminbi, this may temper any potential further US dollar strength.
While all the focus has been on China exporting disinflationary pressures, it is worth reminding ourselves that inflation trends in the US are just as important to the global growth and inflation outlook , given the US economy remains the significant engine of global growth. Month-to-month US CPI has been trending lower since May and the annual rate of inflation held at zero in September . It is no coincidence, however , that this period coincides with the sharp fall in energy prices, so year-on-year comparisons will be distorted.
More important, US core inflation has remained steady throughout this period and currently stands at 1.9% in September. Goods and services inflation remains relatively robust, including housing, medical care services and clothing. It is worth reminding ourselves that the services and consumption sector represent two-thirds of the US economy. US households have significantly deleveraged over the past few years and the evidence suggests that US consumers are starting to borrow again. 'Big ticket' items such as auto sales have been particularly strong. Wage growth remains mild compared to history, but nevertheless pressures are rising, especially in the private sector. Furthermore, rental vacancy rates continue to plummet and this has the potential to exert upward pressure on housing costs, a significant component of US core CPI.
The Federal Reserve remains confident that inflation will return to the longer-term target of 2%. Part of this confidence is rooted in US household inflation expectations, which according to policymakers remain well anchored, despite lower headline measures more recently. Monetary policy affects real economic activity and inflation with a substantial lag and the overall focus among policymakers appears to be on initiating a rate rise sooner rather than later. There is a risk the bond markets might be caught off-side.