Recent CPI inflation data out of both the US (for April) and the Euro zone (for May) were higher than expected. In the US that tells us to be wary about pushing rate hike expectations out too far while the Euro area data confirms deflation fears were overblown.
Annual headline inflation in the Euro zone reached +0.3% in May, up from 0% in the year to April which followed four months of negative readings. The annual rate of core inflation also moved up, rising from +0.6% to +0.9% over the month. This is good news and supports our view that the recent experience of deflation would prove temporary. Indeed we attribute much of the move higher in European bond yields recently to the unwinding of deflation fears.
That said the risk of a period of sustained low inflation in the Euro zone is still as great as it was when the European Central Bank (ECB) increased the size and scope of its asset purchase program earlier this year. We expect GDP growth to remain modest overall with significant spare capacity keeping inflation subdued. We expect the ECB’s asset purchase program to run its full course to September next year.
The +0.3% rise in the core US CPI took the annual rate of increase to +1.8%, or not far off the Fed’s 2% target. Much of the increase can be attributed to core services, in particular owners’ equivalent rent (up 0.3% m/m) and what appeared to be a bit of catch-up in the cost of medical services which blipped 0.7% higher in the month.
We don’t see this as a sudden lurch higher in underlying inflation pressures. Indeed core goods prices remain subdued thanks to low inflation globally and the stronger US dollar. The Fed’s preferred inflation measure, the core personal consumption expenditure (PCE) deflator, also remains subdued rising at an annual clip of just 1.2% in the year to April, down from 1.3% in the year to March.
So is inflation rising or not? I look to the labour market, in particular productivity and unit labour costs, for signs of underlying inflationary pressure. But that data can very volatile quarter-to-quarter and is fraught with measurement challenges. Last night’s release of revised March quarter data will attest to that fact with productivity falling at annualised rate of -3.1% while unit labour costs rose +6.7%. That’s largely the result of weak March quarter growth.
Year-on-year growth rates are a tad more meaningful with productivity up +0.3% in the year to March and unit labour costs up 1.8%. The low productivity result is a continuation of the trend observed since the end of the Great Recession when it has averaged +0.8% per annum, below the long-term trend rate of +2.2%. Unit labour costs, while highly volatile, appear to be trending higher which is consistent with recent trends in indicators such as the Employment Cost Index.
The message I expect the Fed to be taking from this is that despite still low core PCE inflation and the move higher in core CPI not yet being the result of rising underlying inflation pressures, they can still have comfort in their view that inflation will move towards target over time.
It’s interesting therefore that the Fed Funds futures market isn’t expecting rate hikes till the end of the year. While June is highly unlikely, I think a September “lift-off” is still very much live. Interest rates at zero seems inconsistent with an unemployment rate that is trending down towards 5%, low productivity growth and most wage measures tracking higher. Plus getting the first one out of the way means we can start focusing on what matters most – the extent of the interest rate cycle rather than when it starts. In the meantime,back to watching the data….