Daily Economic Briefing: April 19, 2010

Daily Economic Briefing: April 19, 2010

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• The global data flow remains solid with upside surprises tending to occur in the US and Asia. We have begun to raise growth forecasts for the first time in about six months. Most of the changes have occurred in Asia. Growth has been running faster than expected across much of the region, reflecting a combination of robust gains in exports and in domestic demand, leading our team to raise forecasts for 1H10. With a strong foundation for growth and policy set to remain accommodative, the risks are that we will end up boosting forecasts for 2H10 as well. We boosted growth projections for the UK and Brazil. We also have cited upside risk to current-quarter growth in the US, although the forecast has been left unchanged at 4% annualized (1Q growth was raised to 2.9%, however).

• Even as the growth outlook has turned more positive, core inflation keeps sliding in the G-3 economies. US core inflation set a fresh low of 1.1%oya in March. This ties the low set in November 2003 at the height of the previous deflation scare. The recent downward momentum in US core inflation has been powerful: the core CPI has averaged monthly changes of 0.0% over the past five months (seasonally-adjusted) Euro area core inflation, which had fallen to a record low of 0.8%oya in February, edged up to 0.9%oya in March. Our long-standing call is that core inflation in both the US and the Euro area will fall below 0.5%oya later this year.

• The slide in US core inflation is getting attention at the Fed. Chairman Bernanke talked about it last week, and it also was featured prominently in the FOMC minutes. What is key is that Fed officials have been surprised by the extent of the breadth and depth of the decline. It is this surprise to the Fed’s forecast that lies behind our judgment that they will leave policy rates on hold this year despite an increasingly strong recovery in the economy. This judgment also holds for the ECB.

• Some analysts have argued that the decline in US core inflation is narrowly-focused in housing. Fed officials have rejected this view; as do we: alternatives such as the median or trimmed mean CPI are giving the same message as the traditional core measure; likewise, if one strips the core of its tobacco and car price components, which were boosted by tax hikes and the cash-for-clunkers program, in addition to removing housing, the resulting inflation rate is even lower than the official core

• Focusing on this week’s data reports, one focus will be March US durable goods orders. We look for robust gains in both the headline (relating to overall goods demand and manufacturing) and the capital goods components (consistent with expanding capex). The Euro area April business surveys also are due. The flash PMI is expected to rise above the 56.0 mark for the first time during this expansion, consistent with a marked pickup in Euro area growth.

• On policy, the Reserve Bank of India meets tomorrow. The RBI has turned increasingly aggressive, and we look for above-consensus hikes in both the repo rate (+50bp to 5.50%) and bank reserve requirements (+50bp or 75bp to 6.25% or 6.50%). The Bank of Canada’s Monetary Policy Report also is worth watching to see if the BoC signals a rate hike is coming (JPM: July).

Page 2 of 2: Inflation responses to rising unemployment vary widely

US core inflation continued its downward trend in March, falling to 1.1% from 1.3% in February. The core rate reached as high as 2.5% in the second half of 2008. The global core inflation rate, compiled after stripping out the food and energy components of national indexes, mirrors this disinflationary trend. The global core inflation rate fell from 2.3% in late 2008 to 1.3% in February 2010, the latest month available.

The opposite movements have been seen in unemployment rates. The US jobless rate remained at 9.7% in March, down slightly from its October high of 10.1%, but much higher than its pre-recession levels of as low as 4.4%. The global story is practically identical. Global unemployment was measured at 8.4% in February, down from its high of 8.6% set in December. The rate was settled in the 5.4-5.6% range in the eighteen months before macroeconomic conditions deteriorated in 2H08.

This inverse relationship, of falling inflation accompanying run-ups in unemployment, is predicted by the well-known Phillips curve. As output lags relative to potential, an increase in resource utilization slack puts downward pressure on wages and prices.

Looking at available national data, the observed relationship between changes in unemployment and inflation varies widely. For example, the US stands out with the biggest increase in unemployment, yet by comparison, the fall in US core inflation looks relatively modest. Toward the other end of the spectrum, Korea experienced a relatively modest increase in unemployment alongside a fairly sizable decline in core inflation. For an individual country, there are a number of factors that influence this relationship, including changes in currency values, changes in tax rates, and the implementation of government job programs. That said, all the countries in our sample experienced some increase in unemployment and some decline in core inflation during the recent downturn in the global economy.

One interesting question is what happens next to core inflation. Global unemployment has begun to level off and if inflation expectations are tightly anchored, then core inflation might be expected to bottom soon. On the other hand, core inflation may lag unemployment, particularly if inflation expectations move down in response to the past fall in core inflation.

The recent evidence gives a mixed picture. Core inflation recently has edged up in parts of EM Asia and Latin America, where robust growth is bringing down unemployment rates. On the other hand, the core inflation rate is still falling in the US, despite the resumption of above-trend growth there.

ENDS

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