With the unemployment rate at 4.4% (ie. lower that the Fed’s long-run estimate) and most measures of the labour market on an improving trend the Fed is likely to remain committed to returning monetary policy to a more ‘normal’ setting and won’t be derailed by two months of softer inflation.

  • Underwhelming US CPI prints in March (-0.3%) & April (0.2%) are not enough of a trend to de-rail Fed tightening, but should we be alarmed?
  • A number of factors have been putting a cap on inflation for some time now, including modest global economic growth, anaemic wages growth and falling commodity prices as well as structural changes in demographics and technology. 
  • Mid-2016 saw inflation pick up off the back of rising oil prices & improving economic data.
  • This helped cement a more active phase of monetary policy from the US Fed and the end to further easing from the BoJ, ECB and BoE.
  • More recently, however, inflation has turned down a little again - led lower by oil prices and still very soft wages.
  • Although we are still expecting rate hikes in June and September, recent data suggests investors should be alert, not alarmed.

Global Inflation Takes a Turn Back Down

Source: Bloomberg. Data to 15 May 2017.

2016 Reflation, a false dawn?

For much of the past 12 months inflation has been gradually increasing around the world with the recovery in commodity prices and improving economic growth. This led to what has become known as the “reflation” trade, rising inflation, rising yields and an inflection in monetary policy easing. Since early 2017 we’ve seen inflation moderate in the US, China, Europe and Japan as commodity prices have declined from their recent highs, is this the end of the reflation trade or is it just a bump in the road?

Recent US CPI Underwhelms, but not yet a trend

In the US the March Consumer Price Index (CPI) surprised to the downside, falling by -0.3%/mth taking the annual pace of inflation down to 2.4%/yr from 2.7%/yr. This was then followed up by a soft April report, which saw the annual rate moderate further to 2.2%/yr.

At the same time, the US Federal Reserve’s (the Fed) preferred measure of underlying inflation, the core PCE, declined from a recent peak of 1.8%/yr in January to 1.6%/yr in March. Some of this decline can be put down to temporary factors – such as the moderation in oil prices, a decline in mobile phone communication prices, as well as some sharp falls in medical costs but there are also some potential signs of broad weakness in housing and health costs.

….and unlikely to change the Fed’s tightening stance

Given the Fed’s inflation mandate, does this downturn in US inflation mean anything for their monetary policy path? With the unemployment rate at 4.4% (ie. lower that the Fed’s long-run estimate) and most measures of the labour market on an improving trend the Fed is likely to remain committed to returning monetary policy to a more ‘normal’ setting and won’t be derailed by two months of softer inflation.

Our view remains for two further rate hikes from the Fed this year – in June and September. Further, at the December Fed meeting we expect details to be announced around the Fed’s balance sheet, including a start to a ‘tapering’ of the Fed’s Treasury and Mortgage-Backed bond reinvestment program – which will gradually begin to shrink the Fed’s $US4.5trn balance sheet.

Globally, inflation appears to be falling as well

It is not just US inflation that has moderated in recent months. China’s CPI inflation has fallen from a high of 2.5%/yr in January to 0.8%/yr in February, before some recovery to 1.2%/yr in April. This volatility has been driven partly by Chinese New Year effects and, significantly, food prices – which have been very volatile.

Both Japanese and EU inflation is also off its recent highs – with the moderation in oil prices playing a part here. We do not, however, expect that this decline in recent inflation will be enough to push either the Bank of Japan (BoJ) or the European Central Bank (ECB) into easing monetary policy further.

But with labour markets tightening, reflation could just be a matter of time…

So is the global reflation trade over yet? Probably not, with labour markets continuing to tighten and excess capacity being worked out of the system it seems that higher wages and inflation are simply a matter of time, it might just take a little longer than expected.