Some Mid-Summer Thoughts on Inflation – Euro Thoughts – UniCredit Group

Inflation fears are a widespread feeling in markets these days. The recent stream of positive (or less negative) economic data from US, China and Emerging Markets (EM) in general and, to a lesser extent, the euro area has reinforced this feeling. As a consequence, medium-term breakevens have risen sizeably and in meeting with clients and investors you get the clear impression that the market is pondering the idea that sooner rather than later major central banks ECB included will find themselves behind the curve, rushing to implement their exit strategies.

At the current juncture, headline inflation is negative almost everywhere in the G7 space, whereas core prices are proving stickier and in the eurozone they remain well entrenched in positive territory. Interestingly enough, in the euro area we are in a situation where the ECB seems more relaxed than markets on the inflation outlook and a bit more worried than the IMF Staff which in the last Report on the euro area depicted a small risk of deflation throughout the forecast horizon. We share the ECB’s view that deflation is becoming by the day a somewhat-extreme tail scenario, mainly because we have avoided a collapse of the financial system and thanks to the structurally sticky wages and prices in the heavily-regulated eurozone services sector (latest wage rounds didn’t contemplate at all a negative-inflation environment), and thanks to the current very accommodative ECB stance that should prevent inflation from staying negative beyond next Fall. Moreover, like the ECB we see risks to the inflation outlook “broadly balanced”.

Our relaxed stance on eurozone inflation rests on a benign core inflation performance throughout the forecast horizon. In July, with headline at -0.5%, core inflation is already at 1.3%, hence a level not seen since the previous trough. Moreover, in our baseline scenario core inflation has just entered a steady downward trajectory and slows to about zero at the end of 2010. In our methodological set, the output gap has the driver’s seat in determining core prices, with our survey-based measure that so far has correctly anticipated all the turning points in core inflation cycles. The second factor explaining core prices is the cost of labour. Latest available figures for Q1 2009 confirm that Unit Labors Costs (ULCs) are still rising mainly as a consequence of the fallout in labor productivity. This means two things: first, the moderate decline in core inflation seen so far has to be entirely ascribed to the widening output gap; second, once a subdued labor cost dynamics (we expect ULCs growth to be null/moderately negative throughout 2010, together with a cyclical rebound in productivity) adds to the picture, the deceleration in core prices should gather momentum. Considering the usual lags,downward pressures on core inflation should persist until the end of next year. It is no news that it takes time for core inflation to respond to increasing slack in the system.

Assuming oil prices at USD 90pb by the end of 2010 (with the EUR-USD around 1.40), and an upward trend in food inflation, we expect CPI growth to average 0.3% this year and 1.3% next. Keep in mind that currently the ECB pencils in 0.3 and 1.0%, respectively. Of course, a big if is represented by commodity prices. If oil prices accelerate from current levels, the impact on headline inflation will be very visible next year. To the contrary, food prices should be an issue more for EM where their weight in the CPI basket is considerably higher. In the Q3 2009 Euro Compass, Chiara Corsa and Marco Valli carried out a scenario analysis in which they estimated that with oil accelerating to USD 115pb (circa 75% of the oil rally between May 2007 and July 2008), and food inflation at 4.5%, HICP would average 0.5% in 2009 and 2.7% next year.In that case, besides a more visible decoupling between headline and core, a “vigilant” ECB would probably underpin current market fears.

However, looking also at the “moderate” reaction of oil prices to recent good news on the growth front, reasons to remain cautiously optimistic do not lack. My impression is that in the very next months, the benign core inflation trend, coupled with actual negative readings on CPI, may probably take the upper hand and bode well for riskier assets (a short-lived better growth/lower inflation goldilocks) and provide further steam to equities, as it will underpin the belief that central banks (ECB included) may remain on hold for a relatively long time.We actually expect the ECB to remain stuck on rates until the end of next year, chiefly as a consequence of tame prices.

The natural objection from most clients to such reasoning is that I am not contemplating the impact of the massive liquidity injected into the system and of the sizeable expansion in the ECB’s balance sheet. My reply is that in order to have the Fisher equation of Money (MV=PY, where more money translates into higher prices) at work you need a) the economy operating at full employment of resources; b) the liquidity ending in the pockets of somebody (firms and/or households) willing to spend it. Two conditions hard to detect these days in the eurozone economy. When a central bank “creates” base money (M0), it normally generates broad money (M3, the effective money for transactions available in the economy) via the so-called money multiplier. Over the last quarters, the money multiplier has decreased sharply in the wake of a renewed (forced) attitude of banks to retain liquidity and an impaired lending channel.It is no coincidence that the monetary analysis of the ECB with lending to NFCs expected to slow down until mid-2010 – is one of the key dovish factors of the current central bank’s stance. A revived credit channel is much-needed to make the liquidity a factor of worry. At the Eurotower they know it very well. That is why the ECB doesn’t share – for the moment – market concerns on inflation.