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Acceleration in inflation in the United States and the eurozone, slowdown in American consumption growth

Macro Highlights - 7/4/2018

In short
  • In the US, the PCE price index, which is the Fed’s preferred indicator, saw a 0.3 percentage point increase in its annual growth to 2.3% in May...
  • ... this increase in prices has weighed on household consumption, for which y-o-y growth decreased to 2.3% over the same period after 2.6%
  • In the eurozone, overall inflation came in at 2.0% in June due to the rise in energy prices, while the core index was down 0.1 percentage point at 1.0%...
  • ...which supports the ECB’s decision to delay the exit from its asset purchase programme

In the US, the rise in overall inflation limited growth in household purchasing power and consumption in May

In May the rise in inflation weighed on growth in the purchasing power of households as well as consumer spending. As anticipated, the positive impact of the tax cuts effective since January 2018 was not sufficient to offset the negative effec t of inflation.

The PCE (Personal Consumption Expenditure) price index, which is the preferred indicator of the US Federal Reserve (Fed), gained 0.3 percentage point (pp) to 2.3% in May year-on-year. This rise in overall inflation stems mainly from the increase in oil prices, which were up 5.5% on average between April and May 2018. They thus contributed 0.7pp to inflation in May. Excluding energy and food prices, core inflation was up 0.2pp to 2.0% in May, in line with the Fed's target.

  • The moderate acceleration in core inflation should enable the Fed to continue its monetary tightening at a “gradual” pace. Moreover, the central bank specified that its inflation target was symmetrical, meaning that it would not accelerate its rate hikes if core inflation were to rise above its target of 2.0%. While the Fed’s key rate, the fed funds rate, was raised to 2.00% in June, the Fed could make two further 25 basis point hikes in 2018 to bring it to 2.50% in December, and then increase it to 3.25% at end-2019 according to our forecasts.
  • Total inflation figures are consistent with our anticipation of a rise in the Consumer Price Index (CPI) of 2.6% on average in 2018, with a peak of close to 3% in July. The CPI has been higher than the PCE by 0.3pp on average since 2000, due to their different methodology and composition. The weight of energy and housing prices is, for example, higher in the CPI than in the PCE.

Consequently, the acceleration in overall inflation limited growth in households’ purchasing power in May. Growth in households’ real disposable income, i.e. corrected for the increase in prices, slowed to 1.7% y-o-y in May vs. 2.0% in April.

  • The acceleration in inflation more than offset the positive impact of the tax cuts since the start of the year. The breakdown of disposable income at current prices shows that since January, the tax burden has decreased slightly, after the implementation of the tax cuts voted by Congress in December 2017 and in force since January 2018. In May, income tax shaved 0.5pp from growth in disposable income, vs. 0.7pp on average in H2 2017 and 1pp in December.

Thus, after a slowdown in Q1 2018, y-o-y growth in consumption remained contained in April (2.6%) and May (2.3%, after 2.6% in Q1 2018 and 2.8% in 2017), notably curbed by the rise in the oil price and an increase in the rate of household savings by 0.2pp to 3.2% of disposable income in May.

Implications

  • The moderate acceleration in core inflation is likely to enable the Fed to continue its monetary tightening at a gradual pace. We expect it to raise its federal funds rate to 2.50% between now and end-2018 and to 3.25% by end-2019.
  • The rise in oil prices, and thus overall inflation, could continue to weigh on household purchasing power and limit consumption growth in 2018, which we anticipate will come in at 2.7% in 2018 vs. 2.8% in 2017.

In the eurozone, core inflation slowed, which supports the ECB’s decision to delay the exit from its asset purchase programme

Overall inflation in the eurozone rose from 1.9% to 2.0% in June 2018 under the effect of the rise in energy prices, but this figure is unlikely to have an impact on the European Central Bank’s (ECB) monetary policy stance. We thus expect a peak in inflation in July 2018 and overall inflation at 1.7% in 2018 and 1.6% in 2019, vs. 1.7% expected for the next two years by the ECB.

Attention remains focused on core inflation, which was down from 1.1% to 1.0% in June 2018 in reaction to a lower positive contribution from services. The acceleration in nominal wage growth (2.2% y-o-y in Q1) could continue in H2 under the effect of the renegotiations in Germany, but its transfer to the consumer price index is likely to remain weak, according to our foreca sts. Moreover, we observe in the details:

  • By country: prices are increasing in Portugal (+0.6 percentage points (pp) to 2.0% y-o-y) and in Italy (+0.4pp to 1.4%), but to a lesser extent in Spain (+0.2pp to 2.3%) and France (+0.1pp to 2.4%), while growth slowed in Germany (down -0.1pp to 2.1%).
  • By component: the energy sector explains 39% of the rise, while this component has a weighting of just 10% in the index. The contributions of services and industry also remain low relative to their weight in the index: services explain 29% of the rise, with a weighting of 44%, while industrial products are responsible for just 5% of inflation despite their weight of 26%.
  • The weakness of the latter is also observed in the lead indicators of the PMI activity which show an increase in selling prices in the tertiary sector but a decrease for industry.

Thus, the European Central Bank (ECB) is set to remain patient and cautious in managing its monetary policy, leading it to postpone the exit from its asset purchase programme, particularly as long as the increase in prices does not concern all of the countries of the eurozone (broad-based inflation), is no longer dependent on the asset purchase policy (self-sustained inflation), and is not durable at a mid-term horizon. All of these criteria aim to estimate whether inflation will persist in the eurozone.

To this end, Mario Draghi’s speech on 19 June 2018 in Sintra highlighted the importance the ECB lends to this concept, particularly on mentioning the PCCI (Permanent and Common Component Inflation) as an alternative to core inflation. This index, calculated internally by the ECB, notably has the advantage of excluding short-term fluctuations, being less sensitive to the temporary large shock on certain prices and taking better account of the medium-term effects of food and energy prices. It should not be ruled out that the repeated mentioning of this indicator could be a way of communicating less dependence of the ECB’s monetary policy on the upcoming changes in the eurozone’s core inflation index.

Implications:

  • Overall inflation continues to rise in the eurozone, mainly due to energy prices. The drop in core inflation supports the ECB’s decision to postpone the exit from its asset purchase programme.
  • The ECB’s communication, notably in Sintra, highlighted the alternative indices to the core index, which are slightly more inflationary but less volatile, confirming the ECB’s assessment of a gradual upward trend in prices.