Deflation is not the end of the world
As you will have heard on every news programme yesterday and in every newspaper this morning, the UK has slipped into deflation for the first time since the 1960s. Cue much wailing and gnashing of teeth.
Readers of our updates will not have seen this as a great surprise. Nor is it a catastrophe for the economy in the longer term I believe. The reasons for falling prices are rather obvious; sterling is around 5.8% stronger than it was this time last year on a trade weighted basis and the past 12 months have seen a significant decline in oil and food prices. The subsequent effect on imports into the UK means that disinflation is piggybacking on every product that we bring in from abroad. Nothing new there.
As oil prices recover and last year’s declines fall out of the inflationary basket, then this will become less of an issue. We must also remember that wages are now rising by 2% in real terms, forming great conditions for UK consumers to continue spending through the summer months.
Impact on the Bank of England
I doubt this move into deflation will do too much to rate expectations at the Bank of England; since the beginning of the year Governor Carney and the MPC have warned that a month or two of negative CPI could be seen and we are finally seeing them. I maintain our guidance of a rate increase in March 2016 but for votes to come from more hawkish members of the Committee in the coming quarter.
More on this may become clear from the minutes of the Bank of England’s latest meeting that are released this morning. As we wrote in Monday’s Sterling Update, the key to reading these tea leaves is the level of disagreement with the Monetary Policy Committee. The next few months are likely to show diverging views on the level of slack within the UK’s labour market as well as the resilience of inflation and wages. I am fully expecting that the committee was unanimous in holding policy this month and we will have to see just how balanced this agreement is.
Sterling was taken lower on yesterday’s inflation release, except against the euro .
Euro back in the crosshairs
Yesterday saw pronouncements from ECB member Benoit Coeure that the central bank would bring forward some of its quantitative easing spending in the summer to counteract the typical lulls and lack of liquidity that can be seen with half of the market on the beach. While this is not a major change in policy, it gave markets and traders a reason to justify their euro bearishness.
Greece remains a catalyst for weakness in the single currency too. Comments from the Speaker of the Greek Parliament that the payment to the IMF due on June 5th – worth EUR310m – would not be paid if a deal with its lenders had not been reached have helped the euro lower this morning. Repayments in June total EUR1.7bn with the one due on June 5th the first of that tranche. It seems the clock has been set – 16 days until Greece runs out of road.
Fed minutes key to sustaining USD rally
Before that, we have a lot of movement to account for and tonight’s minutes from the Federal Reserve are crucial. A hawkish set of minutes is entirely possible if the tone of committee members continues to show a belief that any weakness seen in Q1 is ‘transitory’. I will be looking out for comments around the strong dollar and the tightening of monetary conditions, and we must also remember that this meeting took place before April’s poor payrolls. Certainly a big part of this USD rally seen in the past few days has been on the belief that markets have got overly dovish ahead of these minutes. They are due at 7pm.
Elsewhere
The Japanese economy was shown to be growing at 2.4% on an annualised basis in Q1. That works out at 0.6% on the quarter. A pick up in investment and a rebuilding of inventories since last year’s recession are the main drivers although the latter is hardly a bullish mover going forward; consumption growth is needed to make sure those inventories are in turn depleted.
