What does higher inflation mean for global interest rates?
The increasingly hawkish language from the Fed and the ECB continues to cast a shadow over the markets. The increase in headline inflation in the UK has also led some to scale back their expectations for rate cuts from the Bank of England. However, the markets are in danger of losing sight of the fact that, given the rise in oil prices, inflation is still remarkably low.
Underlying inflation has remained subdued in the US, despite more than a year of strong growth and tightening labour markets, and two years of sharply rising oil prices. Core inflation is still falling in the euro-zone. Even in the UK, where core inflation has been rising, it remains below 2%.
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The rise in headline inflation has reinforced the Fed's determination to get US interest rates back to more normal levels. But headline inflation will be falling sharply by early next year. That should allow the Fed to put rates back on hold. In the meantime, the evidence of second-round effects is patchy. In particular, we would give little weight to the rise in consumer expectations of inflation in the Michigan survey, which simply tracks the current rate.
This suggests that fears that US rates will rise to 5% or more are well over the top. Our central forecast is that rates peak at 4.5% early in 2006 before falling again in 2007. But equity markets are right to be nervous for other reasons, notably the prospect of a sharp slowdown in consumer spending as the housing market cools.
In the euro-zone, by contrast, the markets still seem complacent about the risks of higher rates. The ECB has not yet begun to take rates back to more normal levels. Continued economic recovery and falling unemployment mean that inflation expectations are unlikely to drop back, even when headline inflation falls. Our end-2006 forecast of 3% for official rates would still leave them at a historically low level, but it is some 50bp higher than what is currently priced into the market.
In the UK, we retain our long-held view that interest rates will fall to 3.5% by mid-2006. Headline inflation should drop back below its target early next year, as energy effects fade and core inflation falls back again in response to below trend economic growth.
Given dearer oil, inflation is still remarkably loThe communiqu from this weekend's meeting of G20 finance ministers and central bankers summed up the current mood in the markets. The participants concluded: we are concerned that long-lasting high and volatile oil prices could increase inflationary pressures, slow down growth, and cause instability in the global economy.'
In one sense we share that concern. The world economy grew last year by around 5%, well above trend. Rising inflationary pressures and hence higher interest rates are normal brakes which will help growth to slow to more sustainable levels. However, some commentators are in danger of running ahead of themselves and worrying too much about the risk of significantly higher rates in the US. Equity markets are still right to worry about growth, but for other reasons.
Let us start with the facts on inflation. Given the sharp rise in energy costs in recent years, some jump in headline inflation was unavoidable. After all, oil prices have doubled since the start of 2004. The real surprise is that core inflation has remained so low. The UK is one of the few countries where core inflation is higher than a year ago, but it is still below 2%.
Indeed, prior to September's Katrina-related rise to 4.7% in the US, headline inflation had been lower than might have been expected too, given the surge in oil prices. Consumer price inflation averaged 2.8% in the OECD economies in August, which is still a relatively low rate. Core inflation in the OECD remained near historic lows at 1.8%.
Even in the US, core inflation actually fell to 2.0% in September from 2.1% in August and July. September was the sixth month in a row in which core prices have increased by 0.1% or less, month on month. In other words, underlying inflation has remained subdued in the US, despite more than a year of strong growth and tightening labour markets, and two years of sharply rising oil prices.
Of course, it is the outlook that matters for central banks, not the fact that current inflation is well-behaved. But that low starting point for core inflation is still important, because it prepares the ground for big falls in headline inflation next year as the impact of higher energy costs drops out of the annual comparison.
The issue is therefore whether central banks can afford to wait, or need to act now to prevent inflation expectations from taking off. That judgement will partly depend on the initial stance of monetary policy. In the case of the US, the Fed is already on a tightening cycle. The rise in headline inflation has simply reinforced the Fed's determination to get rates back to more normal levels. That implies further quarter point increases at each of the FOMC meetings in November, December and January, taking rates to 4.5%.
However, by early next year, US headline inflation will be falling sharply. That should allow the Fed to put rates back on hold. For now, the big concern is that higher headline inflation could trigger a wage-price spiral. In particular, the rise in headline inflation has led to a jump in consumers' expectations for future inflation, as measured in the University of Michigan (UoM) survey.
But we are sceptical of the value of the Michigan data as a leading indicator, as it does little more than reflect current inflation. With September's 4.7% almost certain to be the peak for the headline rate, this suggests that the UoM measure of inflation expectations should fall sharply in the coming months. In the meantime, US workers have been unable to bid up wage growth when economic growth was strong, so it will be even harder for them to do so in future when the economy is slowing.
Other measures of inflation expectations, notably those priced into index-linked bond markets, have remained relatively low. We would give much more weight to that evidence than to the recent rise in gold prices, which appears to be primarily driven by speculative pressures.
Indeed, there are downside risks to our central forecast that rates will plateau at 4.5%. The chances that the Fed will pause before it reaches that point still seem at least as good as the chances that rates will reach the 5% plus that some expect. If the Fed continues to raise rates in quarter point steps at each of its scheduled meetings (and there is no sign that it is ready to step up the pace), it would not reach 5% until May 2006. By then headline inflation and hence inflation expectations should be tumbling.
Moreover, the current focus on headline inflation misses the bigger picture, namely the prospect of a sharp slowdown in consumer spending as the housing market cools and households look to rebuild savings. That is a much better reason to worry about US growth prospects.
What about the ECBThe ECB has been even more explicit than the Fed in stepping up its rhetoric on inflation. Indeed, whereas we think the markets are in danger of worrying too much about interest rates in the US, they may still be complacent about the prospects of rate rises in the euro-zone. We made that point in early September. Since then both interest rate expectations and bond yields have risen sharply, but we think there is more to come.
The main similarity with the US is that euro-zone headline inflation should fall next year as the rises in energy prices drop out of the annual comparison. But the differences are more important. For a start, at 2% euro-zone interest rates are currently much lower than in the US. The ECB has not even begun to take rates back towards more normal levels.
What's more, rising inflation expectations in the euro-zone are driven at least as much by the recovery in the real economy as by the rise in headline inflation.
This relationship is much closer than that between inflation expectations and actual inflation. Compared to expectations, which fell sharply from 2002 to 2004 as the economy struggled, actual inflation has been relatively stable. Hence, as long as the economic recovery continues and unemployment trends lower, it cannot be taken for granted that euro-zone inflation expectations will drop back next year in line with the headline rate.
Nor do we think that the fact that core inflation is likely to remain low will prevent the ECB from raising rates. Core inflation was even lower when the ECB began tightening monetary policy in 1999-2000 than it is today.
It's not just talkWhat about the suggestion that the ECB's bark may be worse than its bite? Central bankers are of course paid to talk tough about inflation, and such talk may be sufficient to lower inflation expectations without the need to act on these threats. Thus the current hawkish rhetoric need not translate into action on rates. However, as the ECB's Chief Economist Otmar Issing says in an interview in the latest edition of Euro Magazine, threats and interpretation alone are not enough over the long term'. That seems doubly true when interest rates are so low to begin with.
The ECB is therefore likely to raise rates in 2006 as the economic recovery gathers pace, largely independently of what happens to inflation. Our end-year forecast of 3% would still leave official rates at a historically low level for the euro-zone, but it is some 50bp higher than what is currently priced into the market. In contrast, expectations for US interest rates may now be too high. As these expectations adjust, that should help to narrow the spread between US and euro-zone bond yields, and undermine the dollar. US equity markets may be relieved, but with growth set to slow sharply as consumer spending falters, a lower path for interest rates will do little to cushion the blow.
By Julian Jessop, chief international economist at Capital Economic
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