What’s behind the fall in inflation?

Market-implied inflation rates have been collapsing globally and have led some to question whether this will cause policy makers to leave monetary policy at near-maximum accommodation, even in the US. While the decline in inflation is real, there looks to be more to the story than meets the eye.

As a first observation, the decline in break-evens, or what markets discount as the gap between conventional and inflation protected government securities, appears closely correlated between US and European inflation markets but the underlying stories don’t seem to be the same. Thus recent weakness in the oil price doesn’t have a constant impact on the different regions, and may be a key issue for the US but not for Europe.

As a second observation, despite the apparent correlation between the moves globally, US inflation has fallen across the curve, while in Europe it is mainly an issue for the 10y part of the curve, and this speaks to more idiosyncratic factors related to negative carry and an imbalance in supply/demand in Europe, against a re-pricing lower of longer-term growth and inflation expectations. Indeed lower inflation looks to have become something of a “new norm” for Europe. As a technical aside, European 5y5y breakevens are now less than 2%, and whilst there is a stronger medium-term trend of inflation expectations in the US relative to Europe, as illustrated by the spread between 5y5y inflation swaps in both markets, the recent weakness in US inflation appears broad based, with core inflation slower in recent months on the back of relentless deflation in oil prices, and TIPS breakevens have declined noticeably, moving to become distinctly unattractive.

With US core goods inflation non-existent or actually negative, it’s services inflation that’s holding up core, and assuming 0% core goods inflation, core services need to maintain trend inflation of 2.7%yoy for overall core inflation to be at 2%. Most services components had been hovering around this sort of level since April 2013 (after the sequestration-driven Medicare cut that drove medical inflation down) but in recent months, only shelter inflation has been over 2% at the core level, and the other components have slowed and in medical services, private providers appear to be delivering important downside pressure on inflation in that particular component. Whilst private insurers’ inflation rarely falls below medicare price increases or the average for hospitals, those levels are being approached, so stabilization may be on the way and we cannot see a fundamental driver for softer education/transportation services inflation, suggesting that the soft patch in inflation may be temporary and not become a substantial risk to expectations of higher rates as the year progresses.

The key data and news flow focus this week will likely be US payrolls and the ECB meeting. Consensus for US September ADP employment is 202,000, and after last month’s stumble in payrolls, we can expect a 210,000 to 215,000 rise in payrolls in September and perhaps a 0.1pp decline in the unemployment rate to 6.0%. A less optimistic expectation might be 6.1%, so still very low, and on consensus, hourly earnings are expected to rise c0.2%mom. Meanwhile, Eurozone 5y5y inflation breakevens are below levels seen before Jackson Hole and it’s apparent that some market participants are beginning to expect a lot from Mr Draghi, with demands for more stimulus over and above what the ECB has announced thus far. But we can expect such demands to be disappointed, with the ECB likely to maintain a wait-and-see stance whilst it assesses its new tLTRO and asset purchases programs, before embarking on anything further – and all that we can reasonably expect from the ECB are details of their ABS and Covered Bond purchase programmes.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla