Forward-looking and short-sighted
Inflation expectations tend to be “over-sensitive” to the current message of business surveys, which have good predictive power over a short horizon only. Still, even if we think the looming acceleration in consumer prices in the US is transitory, its combination with dovish Fed statements will likely push inflation expectations further in the months ahead. The ECB will need to do more to resist contagion. They are already, but they are also making their policy framework more rigid. This will make for an interesting June meeting.
In the US, inflation expectations derived from market pricing continue to rise although observed core inflation has for the second month in a row surprised to the downside. Such disconnect is reassuring, suggesting that investors do not merely replicate the latest trend but behave in a forward-looking manner. Still, one can be forward-looking and short-sighted at the same time. Indeed, even 10-year inflation expectations are very sensitive to the current underlying state of the economy, proxied for instance by the price component of business surveys, which in the case of the ISM index was in February at its highest since 2008. These surveys can be pretty good at predicting inflation a few months ahead and we agree that consumer prices will accelerate into 2021, but it is premature to see in these indicators signals of a shift to a new inflation regime.
However, inflation expectations also take on board judgment calls on the policy stance. The Fed’s pledge to tolerate inflation overshooting is an important shift. We think the Fed will maintain a dovish communication mode during the imminent acceleration in inflation, thus strengthening the credibility of their “Average Inflation Targeting” framework. This should push inflation expectations further up. We think it will be transitory, but it is one of the reasons why we continue to think that even at 1.6% - the level reached last Friday – 10-year yields in the US still have room to climb further.
The ECB pledged to accelerate its purchases in the quarter ahead, thus fighting contagion from the US. Still, the ECB added constraints onto itself. Indeed, they now consider that changing the pace of buying within the agreed envelope is part of the policy stance, which would entail a Governing Council meeting and preferably a new set of forecasts – only available once a quarter, next in June. This makes the ECB more reactive than pre-emptive. We expect a “discovery process” on the European bond market, conducive to volatility episodes.
Christine Lagarde mentioned the government support to business credit as an element of the “financing conditions” the ECB looks at. This brings us back to the financial position of corporates. The liquidity buffers they built last year are broadly intact, which suggests Europe has some time to deal with the long-term consequences of higher corporate debt. All the radical solutions on offer imply some fiscal cost. “Financial engineering” solutions may be preferable.