How will inflation affect monetary policy? – weekly update 2 July

A look back over macroeconomic and market events for the week ending 29 June 2018. Against a backdrop of further tariffs, equity markets softened and bonds rallied. Inflation is now at or above target in many parts of the world, though Central banks appear relaxed for the moment. This week will see PMI readings from a number of countries, before US Non-Farm Payrolls at the end of the week.

Inflation is at or above target across developed markets

Inflation is now at or above target in most of the developed market regions, complicating the outlook for monetary policy. Eurozone CPI increased as expected by 0.1% to 2.0% year on year (yoy), although the core measure, which strips out the volatile elements of food and energy, slipped 0.1% to 1.0% as expected.

In the US, the Personal Consumption Expenditure index, which is the Federal Reserve’s preferred measure of inflation, rose from 2.0% to 2.3% yoy (ahead of 2.2% expected), with Core PCE rising from 1.8% to 2.0% (1.9% expected), in both cases the highest reading since 2012. Central banks spent much of the last few years puzzling over the lack of inflation despite very loose monetary policy and tight labour market conditions; now it has come through we will need to see whether it stabilises.

Markets have been taking these data very much in their stride – in contrast to the shocks we saw at the start of the year – as Central bankers have remained relaxed about the data, talking about the ‘symmetrical’ nature of the target. Our base case remains that inflation will stabilise around the target level, though we still favour positions that would protect more to the upside of this should inflation pressures continue to build.

Other economic data were mixed

US Durable Goods beat expectations at the headline level, with a month-on-month (mom) contraction of -0.6% in May, better than the -1.6% contraction seen in April and ahead of the -1.0% forecast. However, these figures can be skewed by aircraft sales. A better gauge of the underlying economic situation is perhaps the Non-Defence Capital Goods Orders excluding Aircraft, which showed a -0.2% contraction, down from 1.0% growth in April and worse than the 0.5% expected.

US Households also appeared to be spending a bit less, as Personal Spending growth slowed from 0.6% to 0.2% mom (0.4% expected) as Personal Income rose from 0.3% to 0.4% as expected. Eurozone Economic Confidence slipped from 112.5 to 112.3, which was only marginally better than the 112.0 forecast. Japan had some stronger data, as Industrial Production for May showed a boost from 2.6% to 4.2% yoy growth, comfortably ahead of the 3.4% expected.

Last week’s other events

• In Germany, the IFO Business Climate survey reading slipped from 102.2 to 101.8 as expected. CPI inflation slipped from 2.2% to 2.1% yoy. Retail Sales were a big disappointment, falling from 1.0% to -1.6% yoy, against expectations for a rise to 1.9%.
• CPI in Japan remains one of the only major markets to remain below target, though it did accelerate from 0.4% to 0.6% yoy against forecasts for no change (core CPI accelerated from 0.2% to 0.4%, 0.3% was expected).
• The UK Consumer Confidence reading, as measured by GfK, fell from -7 to -9 (no change was expected), whilst the Lloyds Business Barometer slipped from 35 to 29. Net Consumer Credit growth only increased £1.4 billion in May, down from £1.8 billion in April and better than the £1.5 billion forecast.
• In the US, the Kansas City Fed Manufacturing Activity index slipped from 29 to 28 (26 was expected), and the Richmond Fed Manufacturing Index rose from 16 to 20 (15 was expected). The Consumer Confidence measure from the Conference Board dipped from 128.8 to 126.4 (128.0 was expected).

The markets

A general risk-off sentiment saw equities soften and core sovereign bonds rally. Gold didn’t participate, and oil strengthened throughout the week.

One-month performance of major asset classes in sterling terms

Equities

Major equity markets began the week on a sour note, before rallying towards the end of the week, but not enough to fully recover. UK equities were the strongest performer, though still recorded a -0.5% fall for the week, as measured by the MSCI United Kingdom. The MSCI Europe ex-UK index fell -1.1% and in the US, the S&P 500 fell -1.3%. The TOPIX index of Japanese equities shed -0.7%, whilst the MSCI Emerging Markets was down -0.9% having been as low as -2.7% at the close on Thursday.

Bonds

10-year UK gilts were 4 basis points (bps) lower to finish the week at 1.28%, as were 10-year German bunds, which were 4 bps lower to 0.30%, whilst the equivalent US Treasuries were 3 bps lower to 2.86%.

Commodities

Oil continued to rally through the week, closing at US$79.44 per barrel on Friday, whilst gold was softer, falling to US$1,252.60 per ounce. Copper was also weaker, falling below US$3 to end the week at US$2.95 per lb.

Currencies

The US dollar and yen both weakened markedly on Friday against sterling, having steadily risen during the week, whilst the euro was broadly stronger. Sterling closed on Friday at $1.32, €1.13 and ¥146.

The week ahead

US Non-Farm Payrolls on Friday will be preceded by some PMI readings this week. Early Monday morning we will see Manufacturing PMI numbers from the Caixin measure in China (no change at 51.1 expected), followed by UK Manufacturing PMI later on Monday morning (54.0 from 54.4 expected). Monday afternoon gives us Manufacturing PMI from the Institute for Supply Management (ISM, 58.2 from 58.7 expected). Tuesday morning will see the release of Eurozone Retail Sales (1.6% yoy from 1.7% expected). Wednesday will have Services PMI from the UK, Japan and China (details below) and then Thursday sees ISM Non-Manufacturing PMI from the US (58.2 from 58.6 expected). Non-Farm Payrolls on Friday has a forecast of 200,000 jobs added (from 223,000 in May) with Average Hourly Earnings expected at 2.8% yoy from 2.7%. The daily breakdown is as follows:

Monday: Early morning, UK time, will see the Tankan business survey outlooks released in Japan, and the Caixin China Manufacturing PMI is also out in the morning. Aside from the UK and US PMI readings (covered above), the Eurozone also releases its latest unemployment rate.

Tuesday: UK Construction PMI is out in the morning, as well as Eurozone Retail Sales (above). In the afternoon, the US will report May Factory Orders (no growth mom from -0.8% in April is expected).

Wednesday: Whilst US markets are closed for Independence Day, Services PMI numbers are released from a number of regions, including Japan early in the morning, China slightly later in the morning (52.7 from 52.9 expected), and UK also in the morning (no change at 54.0 expected).

Thursday: Eurozone Retail Sales are out in the morning, and then in the afternoon, aside from ISM Manufacturing PMI, we also have the report on jobless claims and the ADP Employment Change report, which will whet the appetite for the main event on Friday.

Friday: In the early hours of the morning, Japan reports a range of data including the Coincident Index and Leading Index, as well as earnings and household spending data. Later we have the UK house prices from Halifax. US Non-Farm Payrolls will be the main draw, as well as the jobs added and earnings numbers. Associated data such as unemployment (no change at 3.8% expected) and participation rate (forecast for no change at 62.7%) will also be of interest.