Triple header inflation updates to test Draghi, Yellen and Kuroda
- Markets have reacted to Draghi’s new-found confidence in the outlook in the EU
- Energy is making a declining contribution to inflation, after oil gave up its gains
- Inflation data is unlikely to be supportive of Draghi, Yellen or Kuroda
Central bankers are out in force this week, basically telling the markets “Trust us, we know what we’re doing”. But the proof will be in the pudding and we will get a taste test on Friday when the latest inflation reports from the US, the Eurozone and Japan are released. While economic growth is picking up in the Big Three economies suggesting it’s time to tighten monetary policy, inflation remains the missing link.
Speaking at a forum on Tuesday, European Central Bank President Mario Draghi said that “All signs now point to a strengthening and broadening recovery in the euro area – deflationary forces have been replaced by reflationary ones”.
However, Friday’s Eurozone inflation numbers won’t provide much support for his positive outlook. Expectations are that the headline rate will be shown to have slipped to 1.1% on an annual basis, a long way off the 2% seen earlier in the year.
As the following chart shows, the culprit will be a declining contribution from the energy sector as oil prices give up last year’s gains.
Nordea EU inflation chart
Source: Nordea. Create your own charts with SaxoTrader; click here to learn more.
Draghi knows the May inflation update will not look good on the surface, and so issued his defence in advance saying “there are still factors that are weighing on the path of inflation. At present they are mainly temporary factors that typically the central bank can look through”.
In other words, for the ECB the core inflation rate, not the headline, will be of most interest. They will be hoping the market forecast is correct and the core rate will be shown to have crept up to 1% year-on-year from 0.9% the previous month.
Financial markets have reacted to Draghi’s new-found confidence in the outlook, pushing EURUSD up to 1.1345 in Asian trading and the yield on the 10-year German bund up 13 basis points to 0.37%. Analysts are expecting the ECB to begin tapering its bond buying program early in 2018 and to be out of the market completely by mid-year, at which point the deposit rate will be raised by 10 basis points from -0.40% to -0.30%.
Federal Open Market Committee chair Janet Yellen also spoke on Tuesday, at a less formal question and answer session in London. In a similar position to Mario Draghi, she will know that Friday’s price index of Personal Consumptions Expenditures, the Fed’s preferred inflation measure, will not be good news, the scene having been set by a surprising fall in the Consumer Price Index earlier in the month.
The following chart shows the current position for the PCE. Expectations are that the annual headline rate will slip again to 1.5% and the core rate to 1.4%.
Personal consumption expenditure trend
Ahead of the release, Yellen’s comment was “what we would worry about is if it looked like inflation expectations were slipping because that could make low inflation become endemic and ingrained. So we certainly want to avoid that”.
Many will point out that it is not a question of “if” inflation expectations will slip; they already have, as shown in the following chart of the break even rate based on a comparison of the yield on 10-year maturity US Treasury bonds and the inflation protected equivalent (TIPS). Investors are buying TIPS on the basis that inflation will average only 1.65% over the next decade, well off the 2% plus they were prepared to bet on a few months ago.
US inflation expectations
Source: Financial Times
Bank of Japan Governor Haruhiko Kuroda will be part of a star-studded central bank panel later today, but he is unlikely to offer any fresh insights into monetary policy. That’s because Friday’s inflation numbers from Japan’s statistics bureau will not change the outlook that inflation is likely to remain low “for the time being”.
Nevertheless, there may be a glimmer of hope in the May Consumer Price Index numbers: the BoJ’s benchmark rate is expected to crawl up to 0.4% from 0.3% on an annual basis and the core rate (excluding energy) to put its head up above 0% – just.
As in the US and Eurozone, the economic situation in Japan is improving and according to the BoJ “the year-on-year rate of change in the CPI is likely to continue on an uptrend and increase towards 2%, mainly on the back of an improvement in the output gap and a rise in medium to long term inflation expectations”.
But in the meantime Kuroda will stick with his yield-curve-control policy, holding the deposit rate at –0.10% and the 10-year government bond yield at “around zero percent”. USDJPY has been taking its lead from the US versus Japan bond spread for some time. The correlation weakened a little last week but seemed to have been re-instated after US bond yields followed German bund equivalents higher yesterday, taking USDJPY along for the ride, as shown in this chart (please click to enlarge)
The European Central Bank and Bank of Japan been pumping out a combined $300 billion of liquidity per month via their QE programs, enough to support financial markets even as the Federal Reserve prepares to wind down its own book.
But inflation is the Achilles heal of each central bank and while they are putting a positive spin on the outlook for prices, the evidence to be presented on Friday is unlikely to be supportive.
– Edited by Robert Ryan
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Max McKegg is managing director of Technical Research Limited. Follow Max here or post your comment below to engage with Saxo Bank's social trading platform.