Global: whose reflation? Martin Enlund Nordea Research, 31 January 2017

It’s not all about Trump. “Reflation” has been in vogue for a few months – helped by higher headline inflation. But the jury is still out on whether it’s a global story or a local/US story. The FX conclusions differ markedly; keep an eye on EA core.

This is a strategy piece not necessarily consistent with Nordea’s forecasts.

• Higher headline inflation welcome for the ECB, but core inflation holds the key • Reflation story mostly American (& USD-positive), unless EA/ROW core inflation picks up • Core inflation well in excess of 1.1% likely needed to sound the all clear

Our view: low conviction on the trajectory of the USD. Like other market participants we await fiscal & trade clarity from Team Trump. Substantial fiscal easing or clear momentum towards moves such as border-adjusted taxes would be USD-positive, as would hawkish balance sheet rhetoric from the Fed. In the absence of such signs, the pair wants to go higher for positioning reasons. As for upward risks; (unilateral) moves by Trump towards import tariffs would be EUR/USD-positive for de-risking / yield spread reasons. Clear signs of higher core inflation could also provide EUR-positive ammunition...

It’s not all about Trump…

The ECB has surprised FX markets recently, with Draghi not being as hawkish as some had hoped at the January press conference, and Nowotny this week dashing new speculation of a near-term taper (“The discussion about our overall economic assessment will probably (take place) in June”). To provide a short answer why this has been a surprise; too much focus on headline inflation! (This applies especially for German media).

We "knew" that inflation was going to come close or reach the ECB's inflation target already six months ago. Oil prices were going to provide a huge boost to the numbers globally (see e.g. Global: are FI markets too complacent? from August. Indeed, only a severe drop in oil prices would have prevented this). nexus.nordea.com/research Chart 1: Oil prices giving a big boost to headline inflation globally, but not for long

Higher headline inflation is welcome for most developed market central banks at this juncture, and reduces the risks of deanchoring of inflation expectations and as such it is modestly net hawkish for the ECB.

However, the surge in Euro Area headline inflation may largely be a temporary effect. Unless energy prices keep trending higher, headline inflation (currently 1.8%) will fall towards core inflation (currently 0.9%) likely starting in March 2017. Core inflation at 0.9% is well below its 1.5% average since 1999.

US headline inflation will also start to drop soon, but in contrast to the EA it will drop towards relatively high US core inflation at 2.2% (core CPI) or 1.7% (the core PCE deflator – in line with its average since 1999). In short, US inflation trends are so far much more benign than those in the Euro Area.

nexus.nordea.com/research Chart 2: Core inflation trends quite different so far

It is true that given recent robust developments in EA labour markets, OECD’s measure of the Euro Area output gap (unemployment vs the natural rate of unemployment) will have closed with a year. This should help core inflation pick up from today’s low levels.

Chart 3: Output gap, schmoutput gap?

It is also true that such measures of the output gap are highly uncertain. For instance, In January 2012, the Fed believed in a longer-run unemployment rate of 5.2%-6.0%, compared to 4.7%-5.0% today. The Fed has lowered its NAIRU estimates as a result of a lack of inflation and wage pressures. nexus.nordea.com/research To further illustrate the uncertainty with such estimates, have a look at G10 output gaps. Given OECD’s estimates, we are supposed to see overheated labour markets and price pressures in both Sweden and Switzerland – incidentally the two countries in the world with the lowest policy rates…

Chart 4: G10 unemployment gaps

The seasonal pattern of EA core inflation implies that core inflation will be range-bound between 0.7% and 1.1% this year (chart 5). For the ECB and the market to sound the all clear on inflation, we are likely to need core inflation numbers well in excess of 1.1%. If we get that, then the reflationary story is truly global in nature – which large implications for ECB policy, German bond yield, and more (EUR-positive).

nexus.nordea.com/research Chart 5: European core inflation – will it break out of its range?

If core inflation instead stays range-bound, the NIRP & QE world as we know it will persist for a while yet. This would also imply that the USD-positive policy divergence theme remains intact, and that the Fed is likely to remain quite alone in the camp of hawkish central banks for now.

In short; go on keeping an eye on Trump's tireless tweeting, but don't forget the potentially game-changing macro drivers such as EA core inflation...

nexus.nordea.com/research

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