Is Inflation Crying wolf?

The ECB met last week on Thursday and left its main policy rate unchanged along with its asset purchase program. Members also reiterated their intent to reduce the pace of purchases in April from 80 billion Euros per month to 60. Mario Draghi was more optimistic during his subsequent press conference than he has been after recent ECB meetings, and noted the balance of risks had improved. The ECB committed last year to maintaining purchases through the end of 2017, which has caused some to speculate that the policy rate could be lifted prior to a wind down of the current purchase program, especially given that year-over-year headline inflation has risen materially in the past two months. Headline inflation for the Eurozone printed at 1.8% in January and 2% in February, which is just above the ECB’s stated goal. Despite this, medium term inflation forecasts were little changed, and Draghi pointed to still low core inflation (0.9%) along with rising geopolitical risks as reasons to be cautious in reducing policy accommodation. 

The Federal Reserve, meanwhile, is expected with near certainty to raise the federal funds rate another 0.25% at its meeting this week as the domestic expansion marches on. While global economic growth forecasts have ticked up, forecasts for first quarter growth in the U.S. are falling. The Atlanta Fed’s GDPNow model is currently predicting 1.2% quarter-over-quarter annualized growth, down from 2.5% less than a month ago. 

Headline inflation in both the Eurozone and the U.S. have made material gains recently, but those have been driven largely by energy costs (oil prices), which rose for most of last year, but are actually down about 10% YTD. This means that unless they start rising again, later this year we will see a drop off in the headline inflation figure for both the U.S. and Europe. The core inflation figures have lagged the headline number for both (charts below) and, given the modest growth outlook, may not catch up. Inflation is a key determinant of the level of longer-term interest rates, and developments in the commodities and labor markets will play a large role in the direction of both. While labor markets have improved, especially in the U.S., and growth has been fairly consistent, thereby helping commodities prices off their lows, materially higher rates would likely derail these trends. This self-limiting dynamic leaves us skeptical that inflation or rates will be taking off over the medium term.

Five Years of Euro Inflation (CPI - white is Headline and orange is Core):

Five Years of U.S. Inflation (PCE - white is Headline and orange is Core):

Source: Bloomberg, Atlanta Fed