Will inflation divergence resurrect policy divergence?

01 Mar 2016

OVERVIEW

  • Policy divergence was the market’s favourite theme of 2015 – the idea that the divergent trends of the European and US economies would lead to a decoupling of the monetary stance, with the Federal Reserve raising rates and the ECB injecting more stimulus.
  • The market has fallen out of love with both sides of the policy divergence in recent months, with increased scepticism both about whether it is appropriate for the Federal Reserve to tighten policy in the face of a weaker global environment and tighter financial conditions and whether the Governing Council is willing to ease policy further following the disappointment that was the December ECB policy meeting.
  • The latest news on inflation suggest that the market might have been premature to write off policy divergence just yet: US inflation is firming and the Eurozone is back in deflation. Another 50 basis points of rate hikes and further easing from the ECB are on the cards this year.

The market has a tendency of making mountains out of molehills when it comes to data surprises. Relatively small movements in data series that are often either on the periphery of the policy debate or are subject to substantial revision get magnified out of all proportion and then rapidly forgotten. Recent news on inflation does not fall into this category. If we are on the cusp of an emerging trend, then the recovery of US inflation and the weakness of European inflation may resurrect the market’s favourite theme of 2015 – policy divergence – and a whole lot more besides.

The demise of policy divergence

The market had long romanced the idea that the divergence in the trajectories of the US and Eurozone economies would inevitably force a divergence in the stance of monetary policy: the Federal Reserve would have to start withdrawing monetary stimulus while the ECB would have to continue easing monetary conditions. Ironically, just as the FOMC was on the cusp of lifting rates off the floor the market was falling out of love with both sides of this divergence trade. First, the market became increasingly concerned that the time was no longer right for the Federal Reserve to raise rates given the deteriorating outlook in Emerging Markets, falling momentum in the services sector of the economy, and a tightening in financial conditions. Second, the failure of the ECB to match expectations at its December policy meeting shook the market’s confidence that the Governing Council was ready, willing and able to do much more. Indeed, early this year as concerns mounted over the resilience of the US economy the market started to contemplate the possibility of policy convergence, with the Federal Reserve eventually easing policy and perhaps even joining the ECB
in negative rate territory.

US inflation

The cornerstone of the policy divergence hypothesis is the belief that the Federal Reserve will  nally have con rmation that inflationary pressures are starting to build. In recent months, many investors had become quite skeptical of this possibility, insisting that in a global economy no country is the true master of its own inflation destiny. Stated differently, a domestic slack-based model of the economy –i.e., one centered on a Phillips Curve framework – was no longer deemed appropriate. But to paraphrase Mark Twain, reports of the death of the Phillips Curve may have been greatly exaggerated. The recently-released CPI and PCE inflation data for January revealed a much-anticipated jump in year-over-year headline inflation, as prior energy price declines passed out of the one-year window. But much more noteworthy was the stronger than-expected rise in core inflation readings. At 1.7 percent, core PCE inflation is now slightly above the median FOMC participant’s projection for core inflation at the end of 2016. Some of this firming is clearly due to base effects related to prior dollar strength. But this is not just a narrative of core goods price deflation moderating. In recent months, core services inflation (which can be thought of as a proxy for domestically generated inflation) has continued to rise gradually and is now above the Federal Reserve’s two percent objective for overall inflation. Digging into the numbers, we also see signs that rising services inflation may be slowly expanding
beyond housing. Other components of services inflation, including medical, recreation and transportation services, have all firmed over the prior six months.

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