Daily Economic Briefing: March 22, 2010

Daily Economic Briefing: March 22, 2010

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Page 1 of 2: Global data summary

• Last week’s data highlight was the February inflation reports for the US and the Euro area, which strongly suggested that large, negative output gaps are driving down core inflation in these regions. DM core inflation already has fallen a lot, and to quite a low level, very early in the process. After all, these economies are going to sustain large output gaps for at least several more years. At 1.3%oya, the US rate is just above the lows reached at the height of the deflation scare in late 2003—two years into the economic recovery. The Euro area rate has fallen to just 0.8%oya, the lowest level in the history of the series dating back to 1991. Japan reports its February results this Friday. A broader core measure that excludes all food, energy, and alcohol is expected to hold at -1.2%oya, the lowest since record keeping began in 1971.
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• Confirmation that output gaps are producing significant disinflation is critical to our macro forecast for two reasons. The core inflation forecast underpins our view that the Fed and the ECB will leave policy rates on hold until next year. In turn, these policy stances create the best chance for rapid growth, which would limit the duration of high unemployment and budget deficits. This is especially true in the US, where the Fed has engaged in extensive credit easing. The risk, however, is that a sweeping decline in inflation might dislodge inflation expectations and produce outright deflation, as in Japan.
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• Looking to this week’s reports, one focus will be the Euro area March business surveys. We put the most weight on the PMI, as we consider its methodology and scope to be superior to the national sentiment surveys. The recovery in Euro area PMI stalled in the past few months as a pullback in services offset gains in manufacturing. Evidence that a pickup in services is driving a renewed upturn in the composite PMI would be positive for 2Q growth.
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• In the US, there are a number of reports this week to keep track of. We look for mixed readings on new and existing home sales in February, which retreated sharply in recent months. The durable goods report should show that while a decline in aircraft orders pushed down the total, core capital goods orders and shipments rose last month as businesses continue to raise capex to close the gap with depreciation and stabilize the capital stock. The first look at 4Q NIPA corporate profits also is due, we look for a near 30% increase in both q/q, saar and oya terms. Finally, the Fed’s Bernanke, Kohn and Yellen all speak this week.
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• The EU summit, to be held Thursday and Friday in Brussels, may produce a showdown of sorts over Greece. The Greeks are pushing for a more formal backstop from Europe to bring down borrowing costs before they come back to market in size in April/May, and reportedly have said they will turn to the IMF without it. German officials appear to be against doing anything more at this time, while others have expressed more sympathy for the Greeks’ request.
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Page 2 of 2: Inflation expectations are a wild card in inflation outlook

The ongoing slide in developed-economy core inflation is evidence that the output gap is damping price pressures. A silver lining is that it affords central banks the flexibility to maintain current policies. The maintenance of these policies, which entail near zero policy rates and significant balance sheet expansion in the US and UK, creates the best chance for rapid growth. Of course, nothing short of a boom will prevent an extended period of chronically high unemployment and budget deficits. Meanwhile, the risk from weaker-than-expected growth is an unwelcome slide into deflation, as evidenced already in Japan.

One wild card in the inflation process is what happens to inflation expectations. Our forecasts that US and Euro area core inflation will fall to about 0.5%oya later this year assumes that inflation expectations remain stable. However, inflation expectations could fall in response to such low levels of inflation. This would reinforce the downward pressure on inflation coming from the output gap, and possibly produce outright deflation.

Past experience shows that inflation expectations moved in sympathy with large, sustained shifts in inflation. Thus, inflation expectations jumped in the 1970s against a backdrop of persistently high resource utilization and rising core inflation, and then retreated in the 1980s and 1990s when central banks brought inflation back under control.

We highlighted the importance of inflation expectations in a Global Issues report last year (“Slack Attack,” May 29, 2009). We estimated the Phillips curve over various time periods and identified shifts in the curve as a change in inflation expectations. The analysis indicated that inflation expectations have fallen below zero in Japan, so that the economy requires a substantial positive output gap in order to generate even a modest rise in prices. Of course, the Japanese experience serves as an object lesson to other central banks. The Fed and the Bank of England stand out with their extensive foray into unconventional policy easing.

So far there is limited evidence of an identifiable decline in inflation expectations. But it is early: the output gap is set to remain very negative in the G-3 well through 2011. This will keep inflation very low for an extended period. The gradual recognition that a sustained downward shift in inflation has arrived could exert a more meaningful pull on inflation expectations over time.

ENDS

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