Macro Weekly – The reappearance of Goldilocks

by: Han de Jong

  • US inflation comes down again
  • Fed is sticking to its guns,…for now
  • Eurozone economy remains robust
  • UK starting to see effects of Brexit and FX weakness
  • China’s slowdown remains slow
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The big macro story for me of recent days is US inflation. The year-on-year rate of the core CPI inflation fell for the fourth month in a row. Early 2015, the rate had been as low as 1.6%. It then rose in a straight line to 2.3% early 2016. In the course of 2016 the core inflation rate stabilised in a range of 2.1-2.3%. During the last four months, the rate has tumbled all the way back to 1.7%. Headline inflation is showing a similar pattern, although its decline has now only lasted three months and it is less pronounced.

This raises a number of key questions. What is causing this deceleration of inflation? Will it persist? Should/will it affect the Fed’s policy? How will financial markets react?

The drop in inflation in May occurred across a wide range of items. Apparel prices, for example, continue to decline and the weak car market is pushing prices for new and used cars lower as well. But service sector inflation is easing too. This probably means that the drop in inflation is due both to some weakness in the economy and also to technology. The latter is a topic I have commented on before. Technology is reducing inflation pressures and I would expect that to continue over time. In fact, I would expect that effect to intensify over time.

The Fed is sticking to its guns,…at least for now

The FOMC hiked rates at their June meeting, as expected. In their written statement, the FOMC indicated they expect official rates to continue to move higher. They did add that they are “monitoring inflation developments closely”. This was not very different, however, from the May statement. The Fed also said they will start the process of reducing the size of their balance sheet, but they did not commit to a specific timing other than “this year, provided that the economy evolves broadly as anticipated.” The details of their approach indicate that they will do this slowly and very cautiously.

Our view has long been that the Fed will hike one more time this year and three times next year. This view is based on the assumption that economic growth remains robust and inflation moves up gradually. Recent inflation data must therefore increase the downside risks to this scenario. If the June inflation data show a further decline, I think the Fed cannot ignore this and there will then be changes to the expected trajectory of monetary policy. While the written FOMC statement felt relatively hawkish, Fed chair Yellen sounded somewhat more dovish during the press conference.

Disappointing data: a new trend or just noise?

Real economic indicators were mixed again in the US in recent days. Retail sales were weak as was industrial production. The question is if this is a trend or just noise. The yield curve has flattened significantly in recent months and the Q1 corporate profit numbers in the national accounts were weak as well. The yield curve and the profits numbers are generally important early indicators of where the business cycle might be going. Despite these two negative signals, I think the weakness in some data looks more like noise than a change of direction.

It is true that retail sales were soft in May. Total retail sales fell 0.3% mom in May after a rise of 0.4% in April. The so called Control Group of retail sales were unchanged in May. However, the April number was revised up from +0.2% mom to +0.6%. April and May together now looks fine and the revision to April shows that these revisions can make a material difference.

The weak industrial production numbers must not be taken lightly, but we have to bear in mind that growth was strong in April. Total industrial production was unchanged in May, but was up 1.0% mom in April. Manufacturing output fell a very disappointing 0.4% mom in May, but after a gain of 1.1% in April.

Business confidence indices remain strong. The Philly Fed index softened somewhat: 27.6 in June versus 38.8 in May. The June level actually beat expectations somewhat and this is still a high level in historical context. The Empire manufacturing index, measuring manufacturing business confidence in the district of the New York Fed, had disappointed strongly in May when it came in at -1.0, but it bounced back strongly in June: 19.8, still one of the highest readings in recent years.

I think it is largely noise

All this data is somewhat confusing. There is no denying that the data has disappointed in recent weeks and months. However, the data does not point consistently to a material downshift in the economy’s growth trajectory. I am therefore inclined to think that the weakness is largely noise.

If I am right that growth is not falling off a cliff, that inflation will remain modest and that the Fed will change its tone if inflation eases further, that will pretty much constitute a Goldilocks scenario. While many commentators argue that financial markets are too complacent, I think markets are not (yet) discounting this reappearance of Goldilocks. If and when they do, risky assets should benefit.

Eurozone growth remains robust

Recent days were quiet on the numbers front in the eurozone. The general picture is that economic growth remains robust, albeit far from spectacular. April industrial production grew 0.5% mom, although this was supported by a strong increase in energy production. In addition, strong growth in Germany compensated for softness in France, Italy and Spain. Still, for the area as a whole, 0.5% growth is very good. Employment growth accelerated somewhat in Q1: 1.5% yoy, up from 1.4% in Q4 2016, continuing its upward trend since 2013.

Starting to feel Brexit?

The UK economy appears to be showing the effects of Brexit and related developments. Many were forecasting an immediate recession after the Brexit referendum, but it is clear that that did not happen. The referendum outcome had changed little immediately for businesses. The currency market, however, took the view that leaving the EU would have negative consequences for the UK in the long term. Sterling dropped like a stone. It has taken some time, but this depreciation is now starting to have an impact on the inflation numbers. The UK’s CPI rose to 2.9% yoy in May, up from 2.7% in April. The national RPI rose to 3.7%, from 3.5%. The rise in inflation is eroding real spending power and increases uncertainty. Perhaps this played a role in the very weak May retail sales numbers. The complicated political situation does little to strengthen confidence and the EU’s starting position in negotiations about the place where clearing of euro-denominated derivative contracts can be located (inside the eurozone or at least the EU) is a direct threat to the position of the City of London. This is all bad news for the UK. Hopefully, it is a wake-up call for the UK’s Brexit negotiators.

The Bank of England, meanwhile, left monetary policy unchanged, but only just. The vote to keep rates unchanged split 5 to 3. The three dissenters favoured a rate hike in response to rising inflation pressures. A rate hike would be another negative for the UK economy in my view. Well, it did not happen, but it does not take much for the MPC to raise rates in the months ahead.

China’s gradual slowdown

We have long argued that Chinese growth peaked in Q1. The question is how rapidly economic growth will slow. Recent data suggests the slowdown is gradual, exactly what the policymakers want. May retail sales were up 10.7% yoy, the same as in April. And industrial production was up 6.5% yoy in May, also the same as in April. Money growth data was touch weaker. We feel confirmed in our view that the slowdown will be gradual and that the rest of the world should be able to cope.