UK and US inflation data jangles nerves
On Tuesday 17 November, the latest UK and US CPI data was released. Inflation rates are a particularly sensitive topic for national economies right now, and depending on which country is under review there are also implications for the world at large.
Crude oil has had a particularly brutal effect on the inflation targets set by countries like the UK and the US. With historically low crude oil prices, it is exceedingly difficult to see increases in costs and rising wages, and the global economy is being dragged into a period of disinflation.
In the UK the October figures showed a year-on-year change in CPI (i.e. an inflation rate) of -0.1%, no change from the month before. The problem with negative inflation is that policymakers at the Bank of England will find little solace in the economy’s growth prospects if prices are being dragged lower, and the situation could just as easily devolve into a deflationary spiral.
Worse-than-expected inflation data will not be conducive to a rate hike by the Bank of England. The reason is simple: rate hikes are used as a contractionary measure. The act of raising interest rates will encourage people to deposit their disposable income in banks and fixed-interest-bearing accounts such as bonds and treasuries. This reduces the money supply further and acts as a disincentive to economic growth.
Inflation and the Fed’s decision on US interest rates
The Fed has multiple policy objectives that it seeks realise in order to justify an interest-rate hike at the FOMC meeting on December 15/16. Chief among them are the following:
- An unemployment rate of 4.9% (at the current rate of 5.00% the Fed considers the US economy to effectively be at full employment)
- A core inflation rate target of 2.0% (the US economy is currently at a rate of 1.9%)
- Evidence of strong and consistent growth of the US economy (non-farm payrolls, PMI data for manufacturing and services, GDP growth et al)
The core inflation rate in the US tracks price changes in a basket of goods excluding fuel costs and food costs. This rate came in at 1.9% for October 2015, no change from the month before. Meanwhile:
- The headline US annual inflation rate came in slightly better than expectations at 0.2%
- The core inflation rate rose month-on-month by 0.2%
- The headline inflation rate also rose month-on-month by 0.2%
Fed concerns about global economic weakness
Market participants will be trying to assess whether the data dovetails with Fed expectations for the inflation target and the current trajectory of the US economy. The likelihood of a December rate hike is all but assured if important metrics like inflation meet with Fed expectations.
Presently the Fed has all its proverbial ducks in a row and there is an overwhelming consensus that a December lift-off will take place. Fed chair Janet Yellen and her deputy Stanley Fischer are of the opinion that conditions on the ground are ripe for a rise, and that a 2.0% core inflation target will be reached over the medium term.
A strong US dollar remains a source of concern for the Fed since it makes it difficult for demand in commodities to be sustained for any reasonable period of time. Further, a strong US dollar is a disincentive to exporters, while making imports more favourable.
The Fed is therefore in favour of gradual monetary tightening as opposed to a sharp rate hike. The October jobs numbers were encouraging and provide further evidence of a US economy on the mend. Weakness in China remains a concern, but the US economy has been able to withstand the pressures and will likely continue to do so in the medium term.
US economy picking up steam
As it stands, US domestic demand is stable and this will lead to increases in inflation over time. Per-hour wages grew $0.09 in October – further evidence of an inflationary uptick. For now, the US economy will have to settle for low inflation as a strong US dollar and low prices for mining and energy stocks are the norm.
One of the FOMC policymakers, Charles Evens, is expecting GDP growth of 2.5% going into early 2017 and he remains confident that the US housing market can assist the economy reach its growth targets. For her part, Janet Yellen continues to remain tight-lipped about future policy decisions.
Credit Suisse in its 2016 Global Outlook has cited an increase in US core inflation and declining Chinese investment spending as the most critical issues facing the global economy. While China has fueled a policy of credit-driven investment spending for years, the likelihood of this continuing at its current pace has declined.
The more credit-fueled investment that China pursues, the greater the likelihood of a financial crisis when investments sour. The sheer size of Chinese capital investment places the world’s #2 economy at risk should an economic contraction suddenly come to pass. The fact of the matter is that China spends substantially more on capital investment than the US spends on consumer goods. Regardless, the likelihood of shrinking Chinese investment is low but if it happens it will impact heavily on the global economy.
What can we expect next?
The US economy has seen increased credit expansion since the 2008 financial crisis and, while wage growth is weak, it is increasing. The only downside is the price of crude oil which is keeping the economy on the back foot. Most pundits expect the price of crude oil to increase midway through 2016, towards the $55 – $65 range. This will fuel the inflation rate and in turn would spur the Fed towards increasing the interest rate.
If both factors come to pass – low Chinese capital investment and steadily rising inflation in the US and the UK – we could be in for a rough ride. The equities market bull run will likely taper off and we’ll see a shift towards treasuries and fixed-interest investments in 2016.
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