A great deal is being written regarding the extent to which the markets are being driven regarding inflation fears and rising base rate expectations. Yet we remain convinced that inflation is not as much of a problem as investors and Western central bankers believe it to be.
Despite the prolonged period of global economic expansion, inflation remains remarkably low by historical standards, despite the recent surge in energy prices. In large part, as we have argued, this is down to the dramatic surge in the global supply of goods caused by the emergence of China as an economic force. This in turn is helping to keep labour costs under control, boosting productivity.
To continue to raise base rates in the wake of an already aggressive period of monetary tightening raises the spectre of an even sharper slow-down than might already be said to be on the cards.
However, feeling the need to keep our eye on the ball, data over the past week has given us an ideal opportunity to gauge just how much inflationary pressure there really is in the system and whether, on that basis, what central bankers are doing is entirely justified.
UK inflation
The Bank’s targeted measure of inflation increased from 2.0% to 2.2% in May, according to the latest data release. Not only was this above the consensus forecast for 2.1% annualised growth, but it is also, of course, in excess of the Bank’s 2.0% medium term target.
Elsewhere, the RPI and the previously targeted RPI-X also rose sharply, to 3.0% from 2.6% and 2.9% from 2.4% respectively.
While this may look bleak, the bad news is really only skin deep. Headline increases were driven almost entirely by increases in energy and seasonal food prices. The breakdown reveals that gas prices increased by 6.0% and electricity by 4.2%. Petrol prices rose by 3.3% over the month. Vegetable prices increased over the month by 1.5%.
Critically, core inflation, excluding energy and food prices actually fell from 1.3% to 1.1% year on year, its lowest level since November 2004.
The Bank’s Monetary Policy Committee, charged with bearing down on inflationary pressure, may chose to highlight the steep increase in the annualised rate of RPI and RPI-X as justification for raising base rates yet again this summer, particularly as the Committee may suspect that it could form the basis for higher wage claims.
Significantly, investors should bear in mind that the Bank has long articulated its concern regarding the level of spare capacity in the economy as justification for earlier rate hikes. The fall in the underlying rate, coupled with the continuing absence of inflationary pressure in the remorselessly competitive High Street does nothing to support the Bank’s earlier assertions regarding the dwindling output gap!
Just as Mr King used the inevitable uncertainty regarding the extent of surplus capacity in the UK economy as a means of corralling support against the market’s desire for rate cuts over 2005, he cannot use the same argument as justification for a further rate hike in 2006. Other Committee members may feel uncomfortable about recommending a further base rate increase based upon headline data which should improve as the annualised calculation of inflation works its way through last year’s energy price hikes and in an environment in which consumers are being squeezed by higher council tax and utility bills.
On balance and despite assertions to the contrary, there is no compelling case for further UK rate hikes in our view. Indeed, as activity slows and the inflationary surge passes, pressure is more likely to build on the downside.
US inflation
The main feature of the May inflation data from the US proved to be another monthly surge in underlying inflationary pressure. Data revealed the third consecutive monthly increase of 0.3%, taking the annualised figure to 2.4% (excluding energy and food inflation). A surge in owners’ equivalent rent, which comprises about a third of the total underlying inflation calculation, by 0.6% over the month takes the annualised figure to 5.6%.
What differentiates the US from the UK and Europe is that the rise in underlying inflation looks more entrenched. It reflects a likely period of increased rental inflation as previously rising house prices have made property ownership less affordable. This, coupled with increased demand for lower priced property has reduced rental opportunities for individuals.
The headline CPI rate increased by 0.4% over May and by 4.2% year on year. The Federal Reserve will have noted the extent to which the headline number has been adversely impacted by higher energy prices and is well aware of the inelastic nature of gasoline prices (the extent to which higher pump prices reduce consumers’ ability to spend elsewhere). Mr Bernanke is also aware of the sustained increase in the underlying rate of inflation (now 2.4% year on year) and the strong likelihood that it will continue to rise. No surprise, therefore, that the financial markets are pricing in an 80% chance of a further 0.25% point increase in the Fed Funds rate at the June 29th FOMC meeting.
We do, however, expect the impact of earlier aggressive monetary tightening to manifest itself in slower activity levels over the months ahead and thus we suspect that the Fed will begin to signal that its work, if not quite over, is nearly done. This is clearly a very positive signal for both Treasury bonds and the equity market, but negative for the dollar which we suspect will resume its decline against other major currencies and limits the scope for European-based investors to benefit from increasing weightings to the US.
Eurozone inflation
In keeping with other developed economies, the headline rate of inflation across the Eurozone increased over May, to 2.5% (previously 2.4%). Again, energy and seasonal food price increases lay behind the increase in the headline rate. On an underlying basis (excluding energy, food and tobacco prices) the core rate fell from 1.5% to just 1.3% year on year, reversing April’s increase.
Country by country, the most benign data emerged from Germany while the least came from France and Spain. Given that the ECB is less likely to look at country disparities and concentrate more on the overall figure (which remains resolutely above the 2.0% medium term target) we suspect that, coupled with if not robust, then rather more secure activity data, enough ammunition exists for the central bank to move short rates marginally higher again whilst keeping a weather eye out for currency strength.
Japanese inflation
If central bankers in the US and Eurozone are on the war path, the Bank of Japan is already on the brink of doing battle. The country’s economy has rebounded strongly over the past year or two and inflationary pressure is building to levels that cannot now be ignored.
The most recent report on corporate goods price inflation revealed an increase of 0.7% month on month (V’s +0.2% consensus). Japan’s equivalent of factory gate inflation is likely to push swiftly through the chain to the CPI as demand has strengthened appreciably in recent months and forward-looking indicators point to continued strength in the months ahead.
The country’s core rate of inflation is still under 1.0% year on year, giving policy-makers the luxury of raising base rates slowly (from zero). However, such has been the strength and speed of the recovery that a single 0.25% nudge on the tiller is hardly going to make a difference. Japanese rates are more likely to be closer to 1.0% than 0.0 in a year’s time, taking the edge off any attempts by the equity market to make up recently lost ground.
Chinese inflation
It should surprise only a few that the ongoing strength of the Chinese economy is continuing to feed through into inflationary pressure. May data reveals a monthly increase in the headline rate to 1.4% (V’s 1.2% in April). The figure exceeded expectations reflecting higher than expected food price increases. Recent flooding should ensure that the near-term outlook is for more of the same.
The strength of non-food items (+1.1% in May against +0.9% over April) indicates that core prices are rising too.
This clearly signals a further monetary response from the Bank of China, hardly a surprise given that the currency, which would normally be expected to strengthen, is pegged to the dollar. Rising inflationary pressure, coupled with a soaring trade surplus ($13.3bn surplus with the US V’s expectations for $12.2bn. The annualised surplus of $47.1bn represents a 57% increase on last year) argues strongly for a decoupling of the renminbi from the dollar. Will the authorities co-operate? Don’t hold your breath!
Inflation and the global economy
This analysis reveals that, although headline inflationary pressure is rising across the developed (and developing world) the underlying picture provides a very different story and certainly a far-from-compelling case for further rate hikes here in the UK.
Increasingly, this rise in inflationary pressure looks to us like a pretty normal event in an economic cycle (there are, of course, obvious differences between the underlying structure of this global economy and that of the past). The monetary response to this cyclical uptick in inflationary pressure is appropriate were one simply to take the blizzard of day to day data at face value.
However, our recent consideration of the underlying structural ill health of the global economy raises the inevitable concern that a more aggressive monetary reaction to cyclical strength risks a deeper and more lasting adverse reaction over the months and years ahead. If this is what Bank governor Mervyn King really means by “a bumpy road ahead” he should know what to do…or what not to do!
By Jeremy Batstone, Director of Private Client Research at Charles Stanley