US inflation is back, ECB and SNB look to stabilise their currencies, BoE takes a risky gamble

Macro Highlights - 9/25/2017

In short
  • US inflation is back, ECB and SNB look to stabilise their currencies, BoE takes a risky gamble
  • Yuan focus: increased volatility against the dollar

Key Takeaways of the week with Sophie Casanova, Economist, Central Banks, Lisa Turk, Economist, United States and François Léonet, Economist, Emerging Markets
  • US inflation climbed to 1.9% in August, up 0.2% from the previous month, supporting our forecast for a 25bp Fed Funds rate hike in December 2017
  • B. Coeuré has confirmed that the ECB could tolerate the euro’s current level, but any further appreciation, especially if it moved quickly, would be unwelcomed
  • The SNB believes that the Swiss franc is now less overvalued, but remains cautious. The BoE has indicated that it wants to raise its rate, but a monetary tightening cycle is not expected

In the US, inflation climbed to 1.9% year-on-year in August, up from 1.7% in July. According to our analysis, inflation looks set to continue accelerating slightly through to the end of the year, supported by a weak dollar, rising producer prices and a mature job market.

While the increase in oil and food prices was a major factor behind the price index’s upturn in August, other subcomponents also supported it. On the one hand, housing prices – representing 33.7% of the total index and cooling slightly since early 2017 – saw their growth pick up pace again in August. On the other hand, some of the exceptional factors that weakened inflation over the previous five months, such as hotel services, telephony and even car rental, have stabilised.

According to our analysis, the slight acceleration in inflation could continue through to the end of the year due to several factors:

  • Since the start of 2017, the dollar has depreciated by 9% in terms of its real effective exchange rate. If the US currency was to stabilise at its current level for an extended period, this could trigger upside pressures on import prices. These pressures would impact prices for goods and services (see left-hand chart).
  • Producer prices for intermediate goods and services are up 3.8% on average since the start of the year. The ISM purchasing managers surveys reveal that this trend could continue: the index for “prices paid” by businesses for services or goods came to 57.9 and 62 respectively, indicating an increase in prices. If this trend continues, producers could pass on the increase in prices for intermediate goods and services to their sales prices.
  • Lastly, the job market is continuing to improve. In July, there were 6.2 million job openings in the US, compared with 5.6 million in January, and we estimate that around two people are available for every open position (number of underemployed people / number of job openings). In addition, 52% of small businesses report that they are unable to find candidates with enough qualifications for their vacant positions, the highest figure on record since this survey was launched in 1996. As full employment has been reached, we expect the tensions on the job market to continue and support an acceleration in wages within a few months. This progress would support inflation.


  • The upswing in inflation confirms our forecast for a Fed Funds rate hike in December 2017. According to Fed Funds Futures, the probability of a 25 basis point increase in December climbed to 46.7% on 15 September, compared with 38.9% the day before the inflation figures were released.
  • All things considered, we expect inflation to continue increasing slightly before closing out the year above 2%.

Looking at the latest developments for the central banks, currency market issues have remained in the spotlight this week.

For the European Central Bank (ECB), B. Coeuré gave a speech on 11 September in which he focused on analysing the implications of changes in the euro’s exchange rate. More specifically, he highlighted that the euro’s rise could have a more moderate impact than previously on the inflation outlook considering the upswing in domestic demand and the ECB maintaining its accommodating monetary policy. 

However, he added: “Exogenous shocks to the exchange rate, if persistent, can lead to an unwarranted tightening of financial conditions with undesirable consequences for the inflation outlook”.

Moreover, he stated that recent changes in the euro/dollar, which appear to be disconnected from the differential for long term yields between the eurozone and the US, “may suggest that we are entering such a situation. That is why he repeated, following on from the ECB on 7 September, that the euro’s volatility is a source of uncertainty that needs to be monitored.

The Swiss National Bank (SNB) held its quarterly monetary policy meeting on Thursday. At the end of this meeting, in line with our forecasts, it kept its key rate at -0.75%.

However, in its release, the SNB showed itself to be slightly less concerned about changes in the Swiss franc. While it reaffirmed that it was ready to intervene on the currency market if necessary, it indicated that, following the franc’s depreciation against the euro and despite its appreciation against the dollar, its currency’s overvaluation had been reduced since its previous monetary policy committee meeting.

Lastly, the Bank of England (BoE) kept its monetary policy unchanged, in line with our expectations, following its meeting on 14 September.

However, its statements appeared to be hawkish. Notably acknowledging the drop in the unemployment rate from 4.4% to 4.3% in July and the higher-than-expected increase in inflation –headline inflation climbed from 2.6% to 2.9% in August, with core inflation up from 2.4% to 2.7% – the BoE revealed that a majority of its members believe that some withdrawal of monetary stimulus could be appropriate “over the coming months”. [...]

Sophie Casanova, Economist, Central Banks and Lisa Turk, Economist, United States 


Increased volatility against the dollar

  • Following a depreciation phase against the US dollar that began in summer 2015, the yuan has appreciated against it since the start of 2017
  • It has also appreciated against its reference basket since May, which could indicate a change of direction in the People’s Bank of China’s policy for managing the yuan
  • It could now focus on the yuan’s relative stability against this reference basket. The yuan’s volatility against the dollar is likely to increase

Following a depreciation phase against the US dollar that began in summer 2015, the yuan has appreciated against it by nearly 6% since the start of 2017, currently trading at 6.56. While this trend is partly attributable to the weak dollar during this period, other factors have also supported China’s currency. The application of measures at the end of 2016 to control outbound capital flows, the good level of trends for growth in the run-up to the 19th Communist Party Congress in October and the upturn in Chinese exports have contributed towards stabilising the yuan. Indeed, it has been only slightly affected by the geopolitical uncertainty surrounding developments in North Korea. This increase in confidence seems to have encouraged domestic export firms to convert a higher percentage of their overseas profits into yuan. In addition, international investors have returned to Chinese portfolio assets, particularly on the bond segment. These factors have paved the way for China’s foreign exchange reserves to pick up again in the past few months, reaching USD 3,092 billion in August following the downturn seen in early 2017. The People’s Bank of China (PBoC) has also announced the withdrawal of certain measures restricting outbound capital flows, which seems to reveal a relative level of confidence in the moderation of selling pressures on the yuan compared with the end of 2016. 

The yuan’s performance must also be assessed in relation to its reference basket of currencies, also known as the China Foreign Exchange Trade System (CFETS) basket. This is made up of 24 currencies based on their representativeness for trade with China. The US dollar represents 22.4%. In relation to this basket of currencies, the yuan has seen minimal changes compared with its levels from the start of the year, indicating that the Chinese currency’s gains against other currencies have been more limited than against the US dollar in 2017. Similarly, the Chinese currency’s strong appreciation against the US dollar since January has been accompanied by a significant depreciation for the yuan against the euro, the Canadian dollar and the Mexican peso. These three currencies are those of the leading countries for goods exports to the US. In this way, the cost in dollars of goods imported to the US from China has remained stable on average since the start of 2017 – with China therefore remaining competitive on this market – while it has increased for these three countries.

While the yuan’s strength needs to be put into perspective, according to the reference basket approach, the logic guiding the PBoC to determine the yuan’s direction seems to have changed. In 2016 and the first part of 2017, the yuan tended to follow an asymmetrical approach. When the US dollar appreciated against the main currencies, the yuan depreciated against it but remained stable against its reference basket. On the other hand, when the dollar depreciated against the main currencies, the yuan remained stable against it while depreciating against its reference basket. This approach has paved the way for the yuan to depreciate slightly based on effective exchange rates, putting an end to its continued appreciation that began in 2005. However, since May 2017, the yuan has appreciated against both the dollar and its reference basket. This development could indicate a change in the policy for managing the yuan rolled out by the PBoC, which is now probably looking to maintain the yuan’s relative stability against its reference basket, while tolerating its increased volatility against the US dollar. The yuan is therefore expected to move more in the same direction than the world’s major currencies against the greenback. The dollar’s weighting within the reference basket was scaled back in January, from 26.4% to 22.4%, which also indicates the dollar’s reduced importance in relation to China’s other trading partners.

While this drive to strengthen the yuan’s stability against its reference basket still needs to be confirmed, it appears to be consistent with the Chinese authorities’ intentions to ramp up the yuan’s use in international trade, particularly with the countries concerned by the One Belt, One Road, Asian Infrastructure Investment Bank or Silk Road infrastructure projects. While the yuan’s internationalisation is moving forward, this is a long-term and non-linear process. Although the percentage of assets denominated in yuan in global foreign exchanges has increased according to the International Monetary Fund, its use in international payments is struggling to take off, even dropping from 2.4% in July 2015 to 2% in July 2017 according to SWIFT. Alongside this, inward direct investments, which involve acquiring long-term interests in companies in China, are down to their lowest level since 2010, indicating a drop in interest from abroad for Chinese growth dynamics in the past few years. If the yuan’s relative stability against the currencies of China’s trading partners was maintained, this would facilitate the yuan’s internationalisation and wider use for trade. October’s Communist Party Congress could help clarify this point.

In this environment, we estimate that the yuan has limited potential for appreciation against the dollar. While the majority of investors expect to see the next Fed Funds rate hike in March 2018, we are forecasting it for December 2017. The latest US inflation figures tend to support this scenario, which would reduce the yield differential between US and Chinese bonds, currently at its highest level for nearly two years. This element could be reinforced by US growth accelerating on the back of the Trump administration’s proposed tax cuts. Over the longer term, as we mentioned in a previous report, interest in international assets among Chinese residents remains high. Indeed, there are limited alternatives for investment in China, encouraging the formation of speculative bubbles on certain assets such as domestic equities, real estate or products linked to informal credit. The continued moderation of real estate trends that we expect to see, the Chinese authorities’ growing focus on bringing informal credit under control, and the relative high valuation of domestic Chinese equities are all factors that are reducing the appeal of local assets and increasing the desire for international diversification. For these reasons, although a possible appreciation phase could be seen before the Communist Party Congress, we are maintaining our analysis for the yuan to depreciate against the dollar, but by less than previously. It could move towards 6.70 against the US dollar by the end of the year, compared with the previous forecast of 7.10. 

François Léonet, Economist, Emerging Markets