Macro Weekly – Higher US core inflation: one off or a new trend?

by: Han de Jong

  • Higher US core inflation not a trend
  • Weak US activity data for January
  • Eurozone industrial sector powering ahead
  • China closes for new Year
180216-Macro-Weekly-1.pdf (126 KB)

Financial markets were spooked almost two weeks ago when US wage growth proved to have accelerated more than was expected. It brought the US inflation outlook even more into focus. The trajectory of inflation is crucially important to financial markets because a deviation from expectations will affect interest rates and, as a result, the valuation of risky assets. If inflation accelerates more than expected, bond yields will rise further, the Fed will be forced to tighten more than expected and this could be detrimental to the equity market. In addition, significant monetary tightening could trigger the next economic downturn.

US core CPI higher than expected in January

So all eyes were on the US inflation report last Wednesday. Headline inflation amounted to 0.5% mom, against market expectations of an 0.2% rise, while the December 0.1% rise was revised to 0.2%. More important, core CPI amounted to 0.3% mom (after a downwardly revised 0.1% in December). 0.3% does not sound spectacular, but it was the highest mom reading since 2006. The yoy rate crept up marginally but, due to rounding, stayed at 1.8%.

We have long taken the view that structural forces in the economy (technology, productivity, global excess capacity etc.) keep a lid on inflation and that these will compensate for the cyclical forces which are pushing inflation higher. But it is a balancing act. Last year, our call was hugely successful as core inflation decelerated from around 2.3% in 2016 to a low of 1.7% mid-2017 despite tight labour market conditions. That optimistic call was regularly challenged, but worked out well in the end. The most recent data raises the question whether we are too optimistic and whether inflation will actually accelerate more than we think this year.

Not a broad-based inflation process

Our US economist, Bill Diviney, has provided some detailed analysis of the January inflation numbers. I think the question we must ask is whether the data is suggesting that strong economic growth is leading to stronger wage growth, leading to higher inflation and whether bottlenecks in the production process are pushing inflation up. Our answer to these questions is that the January inflation numbers do not suggest that is the case. Core inflation was driven by Apparel, up 1.7% mom, Hospital Services, up 1.3% mom and Motor Insurance, up 1.3% mom. This simply does not look like a broad-based underlying inflation process. The monthly rise in apparel prices looks odd as this sector is globally highly competitive. And it would appear unlikely that such increases will be repeated. The rise in hospital services is likely to be more related to sector-specific factors than an underlying inflation problem, as is the rise in the cost of motor insurance. On balance therefore, we stick to our view that cyclical forces will push inflation up from last year’s average, but not by much.

Weak US activity data in January

Other US data released in recent days was generally weak. Retail sales fell 0.3% mom in January after being unchanged in December (revised lower from +0.4%). The so called control group retail sales were unchanged after falling 0.2% mom in December. Industrial production was also weak. Total output fell 0.1% mom, manufacturing output was unchanged, having also been unchanged in December. Weather conditions may have played a role here as very low temperatures and heavy snow in parts of the US may have depressed activity. Strong housing starts in January are not consistent with than bit of speculation We will need to wait and see. But given the recent two-year budget deal, growth prospects for the US economy are not a concern for financial markets.


Eurozone industrial sector powering ahead

Eurozone economic were firm in recent days. Following strong national data, the eurozone industrial production data showed strength. On a mom basis, output rose 0.4% in December, as the yoy rate shot up to 5.2%. Such a growth rate was last seen in 2011, but that was after the sharp contraction of 2008-2010. Under more normal circumstances, the eurozone industrial sector doesn’t reach such growth rates.

Eurozone GDP rose 0.6% qoq in Q4, the same as in the previous quarter. Given further increased momentum in various other economic indicators, we expect GDP growth to accelerate somewhat in the course of this year.

China closes for the Lunar New Year

The year of the Dog has started in the Chinese calendar. The implication is that many Chinese people are travelling for family visits. The economy closes effectively. As Chinese new year fell in January last year, any yoy comparisons of economic data will be distorted. This does not only affect Chinese data, but also the data of countries with close economic ties.