The inflation surge as evidenced by the TIPS market (US Government Treasury Inflation Protected Securities) that started around September ’16 has taken a bit of pause and has actually has started to reverse.
Undoubtedly there were some Trump effects to the inflation rally in the US, which in turn lifted markets globally, but the path to higher inflation prints and decent economic conditions was already in place before the November Presidential election. The election just removed some of the downside tail risks.
However, since inauguration day on 20th January 2017, the level of inflation break-evens in the US are now lower. Some of the enthusiasm based on expectations of a relatively quick implementation of tax reform and infrastructure spending, perhaps financed by either Border Taxes or increased borrowing, has fallen away. Healthcare reform has highlighted how difficult it will be for President Trump to implement changes. Another issue for the inflation market is that we may already have reached the high in the US inflation print for this year, 2.7% CPI recorded in February, which does have a psychological impact.
So where does the market go from here? Expectations are now low for reforms and the medium to long term picture has not changed. The “America First” policy is still alive but it is proving not to be progressing as fast as the market would like. The fundamentals are solid, core inflation in the US is 2.2% (excluding energy and food) and 5 year inflation is priced at 1.85% according the market, so valuations are compelling. However, the pause in the market seems correct as we look for the next catalyst.
The Bank of England has kept its policy rate unchanged at 0.25% and has voted to keep the stock of purchases unchanged by 9-0. This was expected by the market.
The important conundrum for the BoE is if the economy continues to be more resilient than the Banks’ own forecasts, what is its reaction function to above-target inflation?
Within the Quarterly Inflation Report it did indeed improve its outlook for UK GDP. 2017 predictions moved from 1.4% to 2%, coming from both an improvement in household consumption and business investment. At the same time it also moved down its unemployment rate forecast for 2017 from 5.4% to 5%. But it kept its inflation forecast broadly unchanged.
The Bank has managed this by changing its view on how much slack there is still left in the labour market. It does not think wages are picking up fast enough for the level of unemployment that we are at. So it has lowered where it thinks the equilibrium rate of unemployment is – moving this down from 5% to 4.5%.
This gives the Bank of England plenty of room this year to keep interest rates the same even if inflation goes above the target. What will most likely call this into question is if wage growth were to surprise to the upside.
A very interesting throw-away comment from Mr Carney in the press conference: “we are coming to the last seconds of Central Bankers 15 minutes of fame”.
Eurozone CPI has picked up quite dramatically in recent months from 0.5% in October 2016 and just 3 months later to a very respectable 1.8%. Ok, most of this is base effects of energy and food inflation coming through, but the average CPI rate in the Eurozone has only been 1.7% since 2001. At the ECB meeting in December, Draghi managed to extend the current monetary easing QE policy until the end of 2017 when we coming off the back of very low prints. In other words, he had the cover of very low inflation prints to toughen the stance that more monetary stimulus was warranted.
While the 1.8% rate we saw for January is not exactly anything to worry about and the programme will most likely continue in its pre-announced version, Draghi will no doubt play down the inflation prints, stating this is base effects rather than self-sustaining over the medium term. However the disconcerting voices over the QE policy will become louder and I can easily imagine a scenario in the summer months where the “taper” word is being openly discussed.