The Inflation Monster Is Alive And Kicking

Philip Marey, Senior US Strategist at Rabobank

Yesterday’s data from both sides of the Atlantic showed that the battle against inflation is far from over, which means that the ECB and the Fed are not going to cut rates anytime soon. While it has come down considerably, inflation is not falling in a straight line. In fact, in some months, inflation is not falling at all, or it is actually increasing.

Eurozone inflation remained at 5.3% in August. Our ECB watcher Bas van Geffen noted that ECB expectations reversed course after the inflation report for August hit the wires. Markets are now priced for about a one in four chance that the central bank will raise rates in September, down from the 55% odds at Wednesday’s close. The headline inflation rate failed to continue its descent from 5.3%, but on the bright side it didn’t accelerate either – as had been expected following the release of several national estimates. Moreover, core inflation did decline somewhat, as did other measures of underlying price pressures. Our own estimate of super-core inflation dropped 0.3 percentage points, and, notably, services inflation decelerated marginally. Although the latter is admittedly difficult to gauge given the broad range of categories it spans, it is also a closely watched measure by the ECB considering that services prices generally have a closer relationship with wage developments.

Later in the day, the accounts of the July ECB meeting confirmed that inflation developing more or less in line with expectations may just be good enough for the Council to sit on their hands at the next meeting: “Members underlined that there had been no material surprise in the latest inflation outcomes compared with the June projections. This was seen as good news given the earlier streak of upward surprises.” On its own, that’s not the most convincing argument. Crucially, at the same time, the ECB is clearly becoming more concerned about the growth outlook: “signs of a possible downward surprise in economic activity compared with the June projections constituted important news.” 

Bas views these developments as supporting our view that the ECB will take a long pause from here on out, albeit with a hawkish message. The ECB is by no means considering its job done, and the Council is not blind to the upside risks from a resilient labour market, and the potential for wage growth to outstrip the ECB’s expectations. The possibility of rate hikes will be kept firmly on the table, even if the ECB holds rates this month. However, risks are no longer one-sided. The weakness in activity is partially caused by monetary developments and tightening credit conditions; and the effects of past policy tightening have yet to fully materialise. This concern was also raised in the Council’s previous deliberations: “with the current slowdown in activity, the ongoing transmission of past monetary policy actions could lead to a more pronounced deceleration in activity than was necessary to achieve price stability.” In other words, “overtightening would not help bring inflation sustainably to the 2% target if it later led to inflation undershooting.”

Turning to the US, the PCE deflator and its core for July came out exactly as expected by the Bloomberg consensus: 3.3% headline and 4.2% core. This rebound from 3.0% and 4.1% was caused by base effects, as July last year we actually saw a decline in the headline PCE price level month-on-month. For the remainder of the year, we are not likely to see a substantial decline in (core) PCE inflation year-on-year, unless core inflation starts to come down significantly in month-on-month terms. This is largely a services story, with services inflation at 5.2%, in contrast goods inflation is negative: -0.5%. In the same report, there was also an acceleration in real personal spending to 0.6% (month-on-month) in July from 0.4%. However, there was a slowdown in personal income to 0.2% from 0.3% and a decline in the personal saving rate to 3.5% from 4.3%. This is the lowest saving rate this year.

The initial jobless claims unexpectedly fell to 228K in the week ending on August 26, but on average they remained slightly higher in August than in July. Further signs of a loosening labor market were provided by the Challenger job cuts which rose by almost 277% (year-on-year) in August. This follows on weaker JOLTS data for July and the Conference Board consumer survey for August indicating deteriorating labor market opportunities, earlier this week.

After yesterday’s data, the Atlanta Fed revised its nowcast for Q3 GDP growth downward to 5.63% from 5.91% (August 24). This is still an impressive figure. The biggest contributor is personal consumption spending (2.94 ppt), followed by changes in inventories (1.25 ppt).

Yesterday, Atlanta Fed president Bostic gave a speech at a South African Reserve Bank research conference. Although he is currently not a voter in the FOMC, his views give us some insight into the thinking of the doves in the Committee. He said that policy is appropriately restrictive and that “we should be cautious and patient and let the restrictive policy continue to influence the economy, lest we risk tightening too much and inflicting unnecessary economic pain.” However, he did not rule out an additional rate hike: “Should conditions not play out the way I anticipate, and inflation or inflation expectations abruptly reverse course and start climbing, then I would certainly support doing what would be necessary to put the US economy back on a path toward price stability.” What’s more, Bostic said that patience “does not mean I am for easing policy any time soon. Inflation in the United States is still too high. The battle against inflation has seen significant progress. Inflation is well off the very elevated levels we saw in the last year, but it’s essential that it be brought all the way back to our target.”  So even a very dovish FOMC participant does not want an early pivot