Much has been made of how the recent wage data coming from the US was the cause of the correction we saw in asset markets last week. It suggested that the Phillips curve may finally be asserting itself at a time when producer and commodity prices have been rising and the temporary factors cited by the Federal Reserve as holding inflation back are easing.
However, a bigger risk is that inflationary pressures are building in the euro area. The ECB has engineered a huge export of capital from Europe to the United States with its programme of asset purchases since 2016. The ECB’s bond buying programme pushed European yields down and encouraged investors to ‘search for yield’ in relatively more mature US markets that offered higher returns.
Markets got jittery in January after the release of the minutes of the ECB’s Governing Council most recent meeting, indicating that inflation may come through sooner than expected and that the central bank was willing to change its language with regard to its future policies. Investors up until then more or less believed Mario Draghi’s commitment to easy policy for as long as necessary to support the euro area’s recovery and the convergence of inflation towards the bank’s 2.0% target. Very little activity on rates is priced in.
However, there are good reasons to believe that inflation will pick up this year in Europe. Since 2014, capacity utilisation, a measure of the degree to which firms are using their resources, has been creeping up. Part of this reflected the low level of capital expenditure in the bloc and weak bank lending. The acceleration in EZ growth in 2017 caught a lot of manufacturers by surprise, with many increasing capex spending. Imports into the euro area in the year to November 2017 grew by over 7%, with the largest increases in import volumes in machinery from capital goods exporters such as China and South Korea, as well as in energy from Russia.
Nevertheless, capacity remains constrained and inflation is currently much lower than it should be as suggested by the level of utilisation (see chart below). It certainly has the potential to break through the 2% target-level within the next 12 months.
The other indicator that points to a pick-up in inflation is the level of unemployment. It is easy to be deceived by the European jobs market. In most Anglo-Saxon countries, unemployment typically has to fall below 5% before signs of price pressures emerge.
Anglo-Saxon economies tend to have more flexible labour markets that support people who have generalist skills. This means firms tend to report shortages when most people who want a job already have one.
In continental Europe, employment is typically more exclusive. To break into many parts of the French, Italian and German labour market, workers typically need to have specialist skills that cannot be easily transferred to other occupations and require years of training to acquire. Further, the costs of employing workers are typically higher due to taxes and regulation, which encourage firms to substitute workers for machines. Higher rates of unionisation can protect insiders at the expense of outsiders. And more recently, the scale and length of the euro crisis have increased the long-term unemployment of young people. All these factors mean that firms across the EZ are reporting skill shortages despite headline figures of unemployment of around 8.5%.
As the chart below shows, there is a relatively tight relationship between trends in HICP CPI inflation, which the ECB targets through its policies, and the level of unemployment six months prior. It shows that inflation starts to accelerate when unemployment falls below 8.5%, roughly where it is today. It also suggests that based on the steady reductions in unemployment since 2013, inflation is likely to pick up later this year. It is not out of the question that it could break through the ECB’s inflation target.
Together then, both capacity utilisation and unemployment figures point to upward price pressures that are unlikely to be offset by the downward pressures of a stronger euro on import prices. Add to that the strong EZ-wide PMI data and we think there is a strong case for a change in the ECB’s stance in the second half of this year.
Last week’s correction was healthy for equity markets which looked overstretched. But it did little to change the extraordinary fact that more than 15% of bonds on global markets trade with negative interest rates, according to Deutsche Bank. As central banks move from quantitative easing to quantitative tightening in the second half of 2018, that situation will have to change, which would at the very least create a more unstable and volatile market environment as both bonds and equities adjust to their fair values.
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