Disinflation in the eurozone intensifies

by: Han de Jong

Eurozone inflation surprised significantly on the downside in October. While we are not even close to outright deflation, the ECB’s inflation target of “below but close to 2%” is clearly being undershot. This, combined with high and rising unemployment, suggests that monetary and financial conditions in the eurozone are still too tight. We therefore expect the ECB to take action before long.

Meanwhile, the market’s perception of the FOMC statement released last week was that it was more hawkish than expected. Economic data was generally positive, with a rise in PMIs across most countries in October. Japan saw a strengthening of many indicators and the Chicago PMI beat everything as it registered the largest monthly increase since 1983!

ECB expected to act

Eurozone headline inflation unexpectedly fell to 0.7% yoy in October, from 1.1% in September and 2.5% in October 2012. Part of this drop was caused by energy prices, which fell by 1.7% yoy – a little more than expected. Core inflation also eased: 0.8% yoy in October, versus 1.0% in September. We don’t know what caused the fall in core inflation, as details have not been released yet. Part was surely the result of a base effect as the rise in Dutch VAT a year ago fell out of the yoy comparison. Nevertheless, it is clear the process of disinflation continues. High unemployment and weak demand are driving inflation down. Admittedly, the eurozone economy appears to be improving, but the likely acceleration in growth will be vulnerable and probably unable to reverse the disinflationary process


Alongside the publication of the inflation numbers, eurozone unemployment data was released. In previous months, Eurostat had reported a stabilisation of unemployment, but statisticians revised the recent data, which now shows a continued rise in unemployment. As the ECB is aiming for inflation below but close to 2%, the central bank must be deemed to be missing its inflation target. We suspect inflation will fall further in the months ahead, probably to below 0.5%. That would bring the eurozone only one unexpected shock away from deflation. While we do not expect the economy to fall into deflation, one can only conclude that monetary and financial conditions are too tight and the ECB should address that.

Some eurozone members have actually fallen into outright deflation. The ECB cannot take the risk that the whole eurozone be hit by this, but unfortunately, the options are somewhat limited. ECB boss Mario Draghi has mentioned the possibility of a new LTRO in the recent past. That is possible, particularly given the fact the so-called liquidity surplus in the financial system has decreased lately. What argues against a new LTRO is that banks borrowing such money are stigmatised, so the uptake could be limited. The two other options are ‘forward guidance’ and further rate cuts. Indeed, we think that the ECB will provide renewed forward guidance in an effect to bring the yield curve down and the euro with it. Another rate cut now also looks more likely than not, though only in December and not this week. The problem with a rate cut is that the refi is already at a mere 0.5%, and a cut to 0.25% might have little impact. I think its impact will be mainly felt through the exchange rate. I also believe the ECB will be willing to try it in an effort to ease monetary conditions further. Should the disinflationary forces continue to build over the months ahead and actually threaten to push eurozone inflation into negative territory (not our main scenario), then negative interest rates will undoubtedly be back on the agenda for discussion.

Other than inflation data, economic data was in fact quite encouraging. While US numbers are negatively affected by political uncertainty and the government shutdown, eurozone economic sentiment improved a little further in October: 97.8 versus 96.9 in September – the sixth consecutive monthly improvement and the highest level in over two years. This index is a good coincident indicator for eurozone GDP growth and is pointing at modest and modestly accelerating growth. Meanwhile, Spain’s GDP grew by 0.1% qoq in Q3. Although the rise did not amount to much, it was the first positive number after nine consecutive quarterly declines. Of the previous 21 quarters, Spain managed to grow in only four.


131104-Handejong-Eurozone Econ Sentiment Index

Four reasons for softer US data, but they are temporary

Most US economic data has been unconvincing lately. I think there are four temporary factors at play. First is the normal variation in economic data. Retail sales were on the weak side in September, but for some reason, this trend appears to fluctuate from moderate strength to below average without a good reason. Second, the housing market softened on the back of the rise in borrowing costs that occurred following Bernanke’s tapering comments in May. The pace of price rises has abated and pending home sales have fallen five months in a row. The rate on 30 year mortgages rose from 3.4% at the end of April to 4.6% two months later. Rates have since fallen back to 4.1%. We (and the Fed, for that matter) will have to wait and see to what extent the decline in borrowing costs will provide relief. The third factor impacting negatively on US growth currently is the government shutdown. It is hard to assess how big this impact is and how quickly it can be reversed. The Conference Board’s index of consumer confidence fell from 80.2 in September to 71.2 in October, which looks like a direct result of the shutdown. And fourth, fiscal consolidation implemented at the start of the year, (tax hikes and the ‘sequester’) is probably still having a dampening effect on economic activity as automatic spending cuts by the Federal government are continuing. It looks likely that the degree of fiscal tightening will soon fall away sharply.


131104-Handejong-US Chicago PMI etc


Despite all this, some data surprised on the upside last week. The Chicago PMI was the star performer, unexpectedly surging from an already firm 55.7 in September to 65.9 in October. The employment, orders and production subseries all showed an impressive increase. October’s monthly gain was the largest since 1983. This is encouraging, as 1984 was the year in which the US economy registered its highest growth rate in recent history at 7.3%. However, to expect a repeat of the 1984 growth performance in 2014 would be completely unrealistic. For your information, the Chicago PMI reached a level of almost 74 towards the end of 1983. The US ISM did not show such a dramatic move; yet it exceeded expectations, rising from 56.2 to 56.4 despite the shutdown. As the economy normalises and the other temporary negative factors disappear, the ISM may show further gains.

While this is all relatively encouraging, the Fed simply cannot be sure how to interpret the data and it will want to avoid pushing mortgage rates up another 100 bps any time soon. At the FOMC’s October meeting, the members left policy unchanged, only making minor changes to the language of the statement. Market participants read the statement as slightly more hawkish than expected and began worrying about a start to the tapering process in December. While this cannot be ruled out, it seems unlikely to us that the Fed will want to take the risk of being ‘too early’, particularly as the ECB may move in the opposite direction and ease policy further come December.

PMIs and Japan on the rise

The start of a new month always sees the release of PMI indicators in many countries. The number of countries in which the PMI rose in October was far larger than the number in which it declined. Asia in particular saw an improvement across the board, as the gauge of business confidence rose in Japan, China, Korea, Taiwan and Indonesia.

Japan’s economic data released last week was uniformly positive. Apart from its PMI rising to the highest level in three years, Japan reported a fall in unemployment, a rise in industrial production, stronger than expected retail sales, an improvement in small-business confidence and better than expected housing starts, vehicle sales and construction orders. It seems the Japanese economy is gaining momentum.