A swinging global inflation pendulum?
Weighting inflation risks
There is speculation that, at core, markets are reacting to shifting inflation risks. Stabilizing commodity prices, firming DM growth and upside surprises in US and European core inflation indeed suggest that global inflation may have turned a corner. How sustainable is the brightening inflation picture? As ECB President Mario Draghi highlighted last week, it is important to look through short-term wobbles in the inflation data. After all, output gaps remain negative in large DM economies. Moreover, the grind higher in oil prices likely reflects supply as much as demand factors. In other words, part of the oil price pickup should not seep into core inflation. Peering through the recent volatility, financial analysts say global price trends have changed little in recent months. Moreover, market-based gauges of medium-term inflation risk have barely changed since the bond sell-off began. BofA’s survey data show that the consensus sees higher risks around 2015 inflation, but not in 2016. All in all, while the global inflation picture looks more balanced now than during much of the past year, currently low inflation and the moderate growth pace ahead argue against worrying price pressures.
Unfazed core inflation
Global inflation has dropped by 30bp since December, led by DM (Chart 1). The EM composite has weakened modestly, reflecting varied inflation backdrops. CPI inflation remains persistently high in the large EM economies of Brazil (8.5%yoy), Turkey (8.1%) and Indonesia (7.2%). Meanwhile, price pressures remain muted in much of Asia and CEE. This week, Chinese inflation surprised on the downside, sliding to 1.2%, while in Mexico inflation retreated to an all-time low. No clear trend can be established yet. BofA’s Global Optimal Trimmed Mean (OTM) indicator has been moving sideways lately. The current OTMmpace of 2%, however, is hovering below the 2010-13 average of 2.4%. All told, global core inflation is low but it is no longer ebbing.
The long way home
To a large extent, this is not surprising. In January, when Brent oil prices troughed below $50/barrel, we forecast that core inflation in the G-4 economies would stand their ground (Core inflation ducks the oil drama). The model forecasts were broadly on track for the euro area and Japan. Core inflation came in moderately higher in the US, where there has been an unusually wide split between the core CPI – up a bit at 1.8%yoy – and the core PCE – down a bit at 1.2%yoy. Meanwhile in the UK, core inflation has surprised on the downside. Re-running our Bayesian Vector Autoregressive models we find close agreement with our current forecasts. In the US, while core CPI inflation could have ticked down to 1.7% in May, the most likely path is a slow grind higher to wrap up 2015 at 2.1% (Chart 3). Meanwhile in the euro area, core inflation is likely to remain below 1% in coming months before edging higher by yearend.
A matter of balance
At the start of the year option prices pointed to a decline in the risk of below-1% inflation. More recently those probabilities have stabilized: Chart 4 shows that the probability of below-1% inflation five years down the line in both economies has largely moved sideways since April. This suggests that long rates have been rising despite stable medium-term inflation expectations. Risks around short-term expectations, however, have shifted higher. To measure risks around the inflation outlook we look at the distribution of forecasts in Bloomberg surveys. In particular, we measure the skewness of forecast distributions and how they have changed. The results confirm that the balance of risks around 2015 inflation has clearly swung to positive territory (Chart 5). The move has been particularly notable for the US, UK, Korea and Poland. There is less evidence of a meaningful shift in 2016 inflation risks. As Chart 6 shows, the consensus now sees larger upside risks in the US, India, Brazil and Turkey. That said, downside risks now prevail in the euro area, and remain significant in Korea. Aggregating the results we find that the balance of risks to global inflation in 2016 is to the upside, but no more than it was earlier in the year.
Back to the usual grind
The balance of risks around medium-term inflation expectations seem to have changed little in recent months. While the consensus see bigger upside risks to short-term inflation – likely in response to higher commodity prices – median expectations and risk assessments for 2016 suggest no fundamental change. As we noted when the Bund sell-off began, shifting inflation perceptions do not seem to be the key market driver (The disinflation red herring). The wider term premia has indeed not been followed by changed policy views (TIP-ping into a tantrum). On the inflation front, base effects point to rising CPI inflation in coming months in the absence of shocks. While the El Nino phenonmenon could push up prices in India and Indonesia, we think the impact on the rest of Asia will be limited (Asia Economic Weekly). Meanwhile, recent data suggest global growth is improving modestly in 2Q. Negative demand shocks seem to be abating. All in all, global inflation appears to be normalizing but with no signs of strong price pressures ahead. Core inflation will likely edge higher in the largest DM economies but remain at low levels (see this edition’s Euro Area Overview for inflation simulations). The picture remains heterogeneous in EM but we look for a drop in the region as a whole. In 2016, we expect a pickup in DM inflation (to 1.7% from 0.4% this year) outweighing a decline in EM (to 5.7% from 6.1%).