Economics Weekly - Inflation expectations matter for future price developments; Weekly economic data preview - Bank of England quarterly Inflation Report and key UK data feature
Economics Weekly 11 February 2008
matter for future price developments
Are central banks
taking risks with inflation? Inflationary pressures
around the world intensified in 2007. The reason was faster than expected
growth in the global economy. This occurred despite the doubling of oil prices and
the bursting of the housing market bubble in the US and the subsequent
crisis in credit markets. But this faster pace of growth was also accompanied
by higher than expected price inflation. Interest rates were raised in response
in 2007, but are now being cut in those countries that were most affected by
earlier rate rises and the credit crisis. So interest rates are not being
uniformly cut around the world, however. There have been rate rises in China, New Zealand and Australia, to name just a few.
But there have been sharp rate reductions in the US - to 3% currently from
a peak of 5.25% in August last year - and more modest cuts in Canada and the UK. Official rates,
however, have remained on hold in the eurozone at 4% in this period. One of the
key reasons why official rates are being raised in some economies is to head
off heightened inflation expectations. Studies over many years have shown that
higher actual future inflation is a function of where prices are expected to be
- as much as from cost push pressures and from demand-pull factors. Most
central banks around the world accept that there is a need to keep inflation
expectations low in order to prevent higher actual inflation later. So where
are inflation expectations in the US, UK and Eurozone and what influence might
they have on actual inflation and hence official interest rates in the year ahead?
are rising Starting with financial
market expectations, chart a shows that there has been a sharp rise in
inflation expectations in all of the economies concerned. In the US, inflation
expectations are elevated, but the Fed is still cutting rates, because it argues
economic growth will slow sharply and that inflation will fall back in the
medium term so justifying cutting now, even with rising price inflation.
Worryingly for the Bank of England, which is also cutting official interest
rates, inflation expectations are also rising. In Europe, they are also high
and rising, but the ECB is not yet cutting official interest rates. Why does
this matter? Charts b, c and d, show that rising inflation expectations are
correlated with rising actual inflation, so cutting official interest rates
when inflation is rising risks embedding it into the price setting structure of
the economy. The danger is that this is hard to eradicate and the cost, in
terms of lost output (and higher unemployment) in the future, from having to
push up interest rates to higher levels, is greater than if rates were kept a
little bit higher today. But central banks are well aware of this risk. This is
why in the accompanying statement to the recent MPC decision, after the committee
voted to cut rates by a quarter of one percent to 5.25%, the lowest since May
last year, stated: "Given this outlook for inflation, some slowing of
demand growth, by reducing the pressure on capacity, is likely to be necessary
to return inflation to target in the medium term. The Committee needs to
balance the risk that a sharp slowing in activity pulls inflation below the
target in the medium term against the risk that elevated inflation expectations
keep inflation above target.â€ť
A similar view was
expressed by the ECB at its meeting in February. The main message from the ECB
remained its worries about price inflation and is a clear sign that it will not
tolerate second-order effects (i.e., higher wage inflation as a result of
higher price inflation). So a top priority, the ECB says, is the anchoring of
expected inflation, which is even more crucial at times like these when
above-target inflation is expected to persist for â€śa protracted period.â€ť Price
risks are â€śconfirmedâ€ť to the upside, ECB President Trichet insisted, even as
growth slows. This, to us, means that the ECB will pay close attention to the
evolution of inflation expectations.
What does the evidence
suggest about central bank reaction to rises in inflation expectations? We have used household
inflation expectations, as these are most important in spreading actual
inflation in the wider economy, for the US, UK and eurozone. Charts
e,f and g show that there is a very strong correlation between changes in official
interest rates and in inflation expectations. In the US, the Fedâ€™s rate
setting during the last 5 years has been to encourage price inflation
expectations. In other words, Fed rates have been below inflation expectations.
Currently, the Fed is once again cutting interest rates even though household
price inflation expectations remain high. This is not so the case for the UK, where there is a
closer link between actual interest rates and inflation expectations. But the UK has still cut official
interest rates even though inflation expectations are rising, though rates are
coming down from a high level. Some argue that labour market trends suggest
that inflation will be contained, due to high levels of immigration and greater
participation in the active workforce of the UK labour market.
However, the jury is still out on this and in the meantime interest rates are
likely to be cut further. Inflation expectations will limit the room for rate
reductions, however, by the extent that they remain high, particularly if the
MPC is serious about taking them into account.
The ECB is much more
serious about inflation expectations than many other central banks. The chart
shows that the ECB does not cut official short term interest rates if
expectations are rising. This would imply that there will be little or no rate cuts
from the ECB this year, unless inflation expectations fall back. But the key
point is that inflation expectations are still rising. The ECB will not raise
rates, but the risk is that the current credit market situation clears up and
actual price inflation â€“ currently well above the target of at or below 2%, at
3.2% in the year to December - does not fall back and inflation expectations
remain high. In that case the ECB will raise interest rates. In short, we need
to watch the data for inflation expectations as much as for actual price
inflation. In addition, comparing the path of official interest rates and
inflation expectations would seem to us to be a good guide to whether the
current monetary policy stance is too loose, too tight or just about right. Trevor Williams, Chief
Weekly economic data preview W/c
Bank of England quarterly Inflation
Report and key UK data feature
The Bank of England is likely to revise up
its 2-year inflation forecast and dampen GDP growth expectations in its quarterly
Inflation Report, published at on Wednesday morning.
Data showing stronger producer and consumer inflation rates in January are
likely to justify this view in the run up to the release. UK labour market and the
latest external trade data are also due for publication. In the US, advance
retail sales, external trade, Treasury International Capital Systems (TICS)
data and Empire State manufacturing and University of Michigan confidence
surveys for February are released. Also in the US, Fed Chairman Bernanke
testifies before the Senate Committee on Thursday, presenting his latest GDP
and CPI inflation forecasts, which will help inform markets about future
cuts in Fed funds rates. In addition, the first estimate of EU-13 Q4 GDP and
the German ZEW investor survey for February may help clarify the extent of economic
slowdown in the eurozone. This data will be particularly interesting following
President Trichet's downbeat comments on economic
growth during his press conference last week. Q4 EU-13 GDP will complete the
provisional picture of 2008 growth performance in the major economies, see
chart 1. Elsewhere, we expect the Swedish central bank to hold rates at 4% at
its monthly meeting on Wednesday and the Bank of Japan to hold at 0.5% on
â€˘ UK economic data could
underpin the view that CPI inflation is rising, and that the Bank of England is
justified in not replicating the Fed's aggressive action to cut interest rates.
In the run up to the publication of the Bank of England's quarterly Inflation Report,
which outlines the Bank's future view on inflation and growth over a two year
horizon, data on current inflation will add to speculation about the contents
of the report. On Monday, producer input prices for January may be lower on the
month, but up 12.9% on the year, well above factory gate prices, which may be
higher on the month and to 5.1% on an annual basis. Excluding food, drink and
tobacco, factory gate inflation of 2.6% suggests that companies may be taking a
hit on profits, weighing on stock markets. On Tuesday, CPI inflation for
January, may begin its ascent to almost 3% later in the year, see chart 2,
coming in at 2.4% annual growth, up from 2.1% in December. Labour market data
published Wednesday may start to show a slight easing in the jobs market, but
on the whole, employment and earnings growth is still looking solid. Official
(DCLG) and RICS house prices also feature this week, along with the BRC retail
sales monitor, providing useful information on the housing market
and the trading situation in the high street.
â€˘ The key US policy event this week
is Fed Chairman Bernanke's testimony to the Senate Committee on Thursday,
during which he is expected to revise down his 2008 GDP growth forecast from
the current midpoint of 2.1%, but revise up the core PCE forecast from 1.85%.
Nonetheless, advance retail sales for January, published Wednesday, could
rebound to 4.5% annual growth for headline sales and 5.4% for sales excluding
autos. The contents of this report may highlight the pattern of household
discretionary spending and give clues as to whether or not interest rate cuts
have already started to take effect. The EmpireState manufacturing survey
and the University of Michigan consumer confidence
report will give an early indication of economic sentiment in February. On the
balance of payments side, December's external trade deficit and TICS data will complete
the 2007 series. We forecast a cumulative trade deficit of $711bn, lower that
$759bn in 2006, and well covered by $806bn of net-long term securities inflows.
â€˘ The EU publishes its
first estimate of Q4 GDP on Thursday, which is likely to provide justification
for President Trichet's less hawkish stance on inflation and his increased
concern over slower growth expressed during his press conference following the
ECB's decision to hold interest rates at 4% last week. Our forecast is for
quarterly growth of 0.4%, half the growth rate of Q3. The German ZEW survey
published on Tuesday, could confirm a further deterioration in investor
confidence in February. Nichola James, Senior
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