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CPI inflation rose to an annual 3.2% in October, above the Bloomberg consensus forecast of 3.1% but below the 3.3-3.4% suggested in a post a fortnight ago.

The favourable surprise relative to that projection partly reflected a fall in food inflation from 4.9% to 4.2% as fresh food prices increased by less than a year earlier. This is likely to prove temporary, with recent increases in global commodity costs suggesting a rising trend into early 2011, allowing for the normal lag – see chart.

As expected, higher fuel costs added 0.1 percentage points to the CPI headline rate. Services inflation, meanwhile, firmed from 3.7% to 3.8%, mainly as a result of year-earlier reductions in bank overdraft charges and mortgage arrangement fees falling from the calculation.

With little news in today’s report, CPI inflation still appears likely to rise to about 4% by early 2011, reflecting high VAT pass-through, food and energy cost increases and stable “core” pressures. The Bank of England last week revised up its central projection for the first quarter to about 3.5% from 3.0% in the August Inflation Report.

Governor King’s latest exculpatory letter was accepted uncritically by a Chancellor keen to leave the door wide open to “QE2”. The “temporary shocks” defence, however, is wearing thin. Commodity price gains are partly the consequence of a secular rise in demand for raw materials from emerging economies, a trend the MPC has consistently ignored. Similarly, exchange rate weakness has not been imposed on the UK but partly reflects the MPC’s policy choices. The scale of the recent fall is no guarantee that it will not be repeated. The effective rate had also declined by 20% over three years at the end of 1974 but plunged a further 25% over the following two years.

The extent, moreover, to which such “shocks” pass through to inflation, instead of being absorbed by a reduction in profit margins or nominal wages, depends on the stance of monetary policy and its impact on inflationary expectations. A high degree of pass-through is prima facie evidence that monetary conditions are too loose and that the inflation target is failing to anchor expectations, with firms confident that price hikes will not cause them to lose market share because the MPC will tolerate a general rise in inflation.

Global industrial output – as proxied by combined production in the G7 and seven large emerging economies – is back on its post-2000 trend path, having staged a V-shaped recovery since early 2009. The “E7” have accounted for 60% of the rise in combined output, with production now well above trend in these economies, explaining recent evidence of “overheating” – see first chart.

Rapid E7 growth fuels inflation partly by boosting food demand and prices. A GDP-weighted average of E7 consumer price inflation moved above 5% in October and should rise further as a result of recent food commodity price gains – second chart. (The average weight of food in the CPI baskets of 120 non-OECD countries was 37% in 2006, according to a 2008 IMF study.) Pressures, moreover, may be spilling over to non-food prices – see last week’s post on Chinese inflation.

E7 central banks have been trying to tighten monetary policies without jacking up interest rates, which have risen meaningfully only in India and Brazil. An average of E7 short rates remains well below inflation, with the gap widening recently – third chart. This policy approach may have reached its limit. The last tightening cycle, in 2007-08, ended only after the average interest rate had risen above headline inflation.

E7 growth outperformance since early 2009 has been supported by faster monetary expansion but real M1 has slowed recently, narrowing the gap with the G7 – fourth chart. Rising inflation and further policy tightening – particularly if in the form of higher interest rates – could sustain this trend, in turn suggesting that E7 relative economic performance will be less impressive during 2011. Emerging market equities may not be priced for this outcome, currently trading on a higher price to book than developed markets.

Widespread pessimism about labour market prospects has been fuelled by a recent fall in the stock of vacancies accompanied by a rise in claimant-count unemployment, as well as looming public sector job cuts.

Strong GDP growth in the second and third quarters, however, suggests that labour demand should be picking up. Such a scenario is supported by the Monster employment index, which tallies vacancies posted on corporate career sites and job boards. The index tracks or leads the official vacancies series and rose further in October, reaching its highest seasonally-adjusted level since December 2008 – see first chart.

Recent consumer survey evidence is also reassuring. Despite media negativity, the net percentage of respondents expecting unemployment to rise has fallen back after a post-election spike and is far below the recession peak in January 2009 – second chart.

The OBR forecasts a fall of 610,000 in general government jobs but this is scheduled to occur over five years – the projected reduction by March 2012 is only 60,000. Overall employment rose impressively during the 1990s despite a larger public sector decline – third chart.

Chinese consumer prices rose by an annual 4.4% in October as food price inflation accelerated to 10.1%, in line with a forecast made in a post a month ago.

The first chart shows the CPI for food together with a weekly index of product prices that was suspended in early October, perhaps because food inflation was becoming politically sensitive. Global prices – as measured by the CRB spot foodstuffs index – have stabilised in recent weeks. This and official price suppression efforts may prevent a further rise in annual CPI food inflation in November.

Looking further ahead, the CPI for food rose steeply between November 2009 and February 2010, implying a possible fall in annual inflation by early 2011. It is normal, however, for price increases to accelerate into Chinese New Year and global pressures may persist as the Federal Reserve moves ahead with “QE2”. CPI food inflation, in other words, may stabilise at around the current level but is unlikely to fall much.

Headline CPI inflation, meanwhile, could rise further as other prices accelerate. The non-food CPI rose by only 1.6% in the year to October but correlates with producer prices, which are picking up. Surging input costs suggest that the annual PPI increase will climb to 10%, in which case non-food CPI inflation could reach 2.5% – second and third charts. Assuming no change in food inflation, this would push the headline CPI rate up to about 5% (food has a one-third weight in the basket).

The November Inflation Report suggests that the MPC is badly split and unlikely to be able to muster a majority for action – in either direction – for the foreseeable future. In a now-familiar routine, the Bank has been forced to raise its near-term inflation forecast significantly but continues to project an eventual decline to the 2% target, based on a “neo-Keynesian” model emphasising the “output gap” and fiscal tightening. The alternative “monetarist” view that persistent inflation overshoots reflect an excess of the supply of money over the demand to hold it – with demand depressed by the Bank’s imposition of negative real interest rates – is ignored.

Observations:

• The MPC’s bias is summarised by its mean forecast for inflation in two years’ time based on unchanged policies – a sub-target figure signals an inclination to ease and vice versa. The forecast was 2.0% in August and looks unchanged in November, based on the fan chart (the Bank refuses to publish the numbers until a week after the Report). So policy remains stuck in neutral despite recent upside growth and inflation surprises. (The gilt market, bizarrely, was discounting a shift to an easing bias, judging from today’s sell-off.)

• CPI inflation is now expected to rise further to about 3.5% in the first quarter of 2011 compared with a forecast of 3.0% in the August Report, reflecting commodity price gains and a weaker exchange rate. It remains at or above the 3.1% letter-writing threshold until late 2011, implying that Governor King will have to wheel out his “temporary shocks” argument in at least four further missives to the Chancellor (including one next week following the October CPI report).

• The 3.5% first-quarter forecast is above consensus but probably still too low – a previous post suggested a rise to about 4% by early 2011 based on high VAT pass-through and transmission of recent food and energy commodity price increases.

• The GDP growth forecast looks little changed from August, implying a mean expectation for 2011 expansion of about 2.5% compared with the OBR’s 2.3% assumption, i.e. not materially different. Claims that the Bank is significantly more optimistic based on its modal forecast are wrong, ignoring a downward risk skew. The OBR is hardly a fount of wisdom, with its June projection of 1.2% growth in 2010 far below a likely outturn of 1.8%.

• In a press conference reply, Governor King claimed that the MPC is required to set policy to achieve 2% inflation in two or three years’ time but the remit states that the target applies “at all times” and makes no reference to the exclusion of “temporary shocks”. The November Report mean forecast implies that consumer prices will rise by more than 2.5% per annum over the coming two years.

• The September level of the CPI was 3.2% higher than if the Bank had achieved 2% inflation since the target was switched from RPIX in December 2003. The Bank’s forecast implies that this overshoot will increase further, to about 4.5% by the end of 2012. Has inflation targeting become meaningless?

Previous posts highlighted a widening monetary divergence within the Eurozone, with real narrow money M1 still growing solidly in “core” economies (i.e. Germany, France, Benelux and Austria) while contracting the “periphery” (Italy, Spain, Greece, Portugal and Ireland). The latter trend suggested renewed economic weakness that would undermine fiscal consolidation plans.

Industrial output numbers for September are consistent with the theme, showing modest pay-back for August strength in the core but more pronounced weakness in the periphery. With several countries still to publish, core output probably fell by 0.5% on the month versus a 2% decline in the periphery. This would imply that peripheral output is now below its level six months ago – see first chart.

With real M1 contraction accelerating, economic news in the periphery is likely to continue to worsen into early 2011.

More US banks eased credit standards on commercial and industrial (C&I) lending than tightened in the three months to October, according to the latest Federal Reserve senior loan officer survey. The net easing percentage leads economic activity and the latest reading is consistent with solid US expansion in early 2011, a prospect also signalled by recent monetary trends – see first chart and previous post. (The chart shows an average of separate series covering lending to larger and small firms.)

Further evidence of improving loan supply is provided by the October National Federation of Independent Business survey, showing a fall in the net percentage of small firms describing credit as hard to get to its lowest level since August 2008 – second chart.

While supply is easing, loan demand remains weak, reflecting ample corporate free cash flow and more attractive borrowing opportunities for larger companies in credit markets. The net percentage of banks reporting stronger C&I loan demand fell back in October and remains in negative territory, although far above last year’s low and at a level historically consistent with stable or modestly-expanding lending – third and fourth charts.

A post in July argued that global industrial momentum would revive in late 2010 in lagged response to faster growth of G7 real narrow money M1 since the spring. Last week’s manufacturing purchasing managers’ surveys for October were supportive, showing the first improvement in new orders since April – see first chart.

The acceleration in G7 real M1 has stalled recently, though growth remains respectable – second chart. The message is that global economic expansion will continue but at a slower pace than from mid 2009 and mid 2010, when industrial output staged a V-shaped recovery. Such a scenario would maintain the resemblance of the current global upswing to that following the first oil crisis recession of 1974-75 – third chart.

What could go wrong? As previously discussed, one risk is that higher commodity prices stemming in part from US “QE2” lift G7 inflation and deflate real M1 expansion, as well as forcing further monetary tightening in overheated emerging economies.

Within the G7, real M1 growth has picked up strongly in the US while continuing to slow in the Eurozone – fourth chart. Until recently, economic news has tended to surprise positively in the Eurozone while disappointing in the US but this trend should now reverse, lending support to the US dollar versus the euro.

In early evidence of such a shift, last week’s US PMIs were stronger than expected and better than those in the Eurozone. Payrolls and vehicle sales numbers were also upbeat. By contrast, German manufacturing orders fell by more than expected, albeit following significant strength. As expected given monetary weakness, there was further bad news from the periphery in the form of weaker Spanish industrial output – fifth chart – and a slump in Irish consumer expectations – final chart.

Bond yields fluctuate with economic momentum. Korea’s export dependence makes its economy especially sensitive to shifts in the global cycle. Its bond yields, therefore, often lead movements in US Treasuries.

For example, Korean 10-year yields plunged by 60 basis points between February and March, bucking a rising trend in the US. This proved a timely warning of an April peak and subsequent big decline in Treasury yields – see chart.

The two markets are now diverging again, with 10-year Korean yields up by 60 basis points over the last three weeks versus little change in the US. If the Korean rise reflects stronger global / US economic momentum, Treasury yields should follow, notwithstanding Fed buying.

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COMMENT:
AUTHOR: plops
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DATE: 11/05/2010 06:07:37 PM

yes but korea has no QE … and as you point out, its export dependency had implied USD dollar buying by korean authorities which in turn … buy treasuries with the dollars.

perhaps more appropriate would be to compare korean headline inflation with US core PCE … seems to me US is creating inflation everywhere in world.

cheers

Recent news supports the earlier forecast of a rise in CPI inflation to about 4% by early 2011, from 3.1% in September. October figures, released on 16 November, may increase to 3.3-3.4%.

• BRC shop price inflation moved up by 0.4 percentage points between September and October. The BRC survey covers non-energy goods, which constitute about 46% of the CPI. Impact on headline CPI rate: +0.2 percentage points between September and October.

• Higher petrol / diesel prices in October versus little change a year before should push motor fuel inflation up from 9.3% in September to about 12%. Impact: +0.1 percentage points in October.

• Commodity price pass-through should result in CPI food inflation rising to at least 7% versus 4.9% in September. Impact: further +0.2 percentage points by early 2011.

• Bank of England survey evidence points to much higher pass-through of the coming VAT hike to 20% than for this year’s return to 17.5%. Impact: up to +0.6 percentage points by early 2011.

• The rise in gas tariffs announced by Scottish and Southern, if followed by other suppliers, will push the CPI gas change up from an annual -5.7% to 3% by January and 9% by April. Impact: +0.4 percentage points by April 2011.

The CPI profile shown in the chart below superimposes these factors on a stable underlying inflation rate of 2.25-2.5%. It suggests an average CPI rise of 3.9% in 2011, with inflation at or above the 3.1% letter-writing level throughout the year.