Central bankers are starting to worry about the Philips curve. The Philips curve describes the relationship between unemployment and the inflation rate. The theory goes that as the unemployment rate goes down, wages will start to go up, and that will cause inflation as companies raise their prices in order to pay their workers more.
As you can see, unemployment in major countries around the world is at or near a 20-year low, more in several cases (although the EU is lagging behind here).
That – or something – is starting to push up wages in some of the major economies. Slowly but surely, wage growth is accelerating. We saw that particularly this past week in the UK, where wages growth surprised on the upside.
Higher wages are making investors in many places expect higher inflation, which means more likelihood that central banks would start hiking rates.
Of course that process is most advanced in the US, where the Fed is already considering what the end point of its hiking cycle should be. Nonetheless, US rates continue to rise faster than in most other countries. Despite all the other drama on the world stage – Brexit, the Saudi controversy, the US-China trade war, etc – this simple fundamental of FX economics was perhaps the dominant factor over the week. There was an extremely strong correlation between how much US 2-year yields rose or fell vs another currencies’ yields and how much the dollar rose or fell vs that currency.
The FOMC minutes didn’t really tell us anything we didn’t know already, but perhaps that was in itself something – it looks like there was no post hoc attempt to shade them to take into account the market turmoil or Trump’s whinging about higher rates. That suggests it’ll require something really, really big to divert them from their path of gradual interest rate hikes.
Meanwhile, it remains to be seen who’s going to follow the Fed and when – despite rising wages in other countries, several have some special feature (like the impending collapse of the economy in the case of Britain, or the impending implosion of the third-largest economy in the case of the EU) that’s likely to keep them from keeping up with the Fed. In short, the monetary divergence play raises its head once again!
The coming week: ECB, Bank of Canada, PMIs
Trench fighting in the First World War was described as “months of interminable boredom punctuated by moments of terror.” That’s something like what we’ve got coming up this week. Monday there’s only one indicator out all day and no speeches. Tuesday is hardly any better, just a couple of speeches, and Friday there’s really only one major indicator (US Q3 GDP). But Wednesday and Thursday…
Wednesday we get the preliminary purchasing managers’ indices (PMIs) for the EU and US, plus the Bank of Canada meeting, plus the Fed’s Beige Book.
The global PMIs are remarkably good for so long into an expansion. While the pace of expansion is decelerating, as you can see there are no major countries below the 50 line. (I don’t include Turkey, which is at an abysmal 42.7.)
France, Germany and the EU as a whole are expected to decelerate further, but the US manufacturing PMI is expected to be unchanged. That should be further support for the monetary divergence idea, as the Eurozone monetary authorities have shown some caution about hiking rates owing to the perceived fragility of the economy, while the US authorities on the contrary have shown their determination to hike rates because of the strength of their economy.
Next up is the Bank of Canada meeting. What’s there to say? The market puts a 95% probability on a rate hike here. The question then is what kind of forward guidance do they give on rate hikes after that. Currently, the market sees a 50% probability of one more rate hike after that by March 2019, bringing the rate to 2.0%. But the odds of two hikes by then is growing – that’s seen as slightly more possible than no hikes by that time.
At the time of the last hike, in July, the statement following the meeting said:
Governing Council expects that higher interest rates will be warranted to keep inflation near target and will continue to take a gradual approach, guided by incoming data.
They repeated that idea at the next meeting in September, saying:
Recent data reinforce Governing Council’s assessment that higher interest rates will be warranted to achieve the inflation target.
The main question is whether they will still see the need for higher rates after this hike. I expect they will. The BoC’s overnight rate is still deeply negative on a real (inflation-adjusted) basis. There’s plenty of room to hike further before getting anywhere near restrictive. Before the global financial crisis, the BoC’s real overnight rate averaged 2.2%. Even if we assume that’s fallen in half, that would still leave room for about four more rate hikes after next week. I expect that they will pledge to keep hiking rates and that the market will take that as a bullish sign, pushing CAD up further. The resolution of the NAFTA brouhaha should also add to the BoC’s confidence that they can keep hiking without throwing the economy into a tailspin.
Thursday, the market will be waiting for the dulcet and mellifluous tones of the redoubtable Mario Draghi at the ECB meeting.
Recently, the market has gradually brought forward its estimates for when the ECB might hike rates. That’s probably due to Draghi’s optimism even in the face of evidence that the EU economy is slowing.
On 24 September, he told the European Parliament that he sees a “relatively vigorous” pickup in underlying euro-area inflation. That suggested the ECB is planning to raise rates sometime at least.
Personally I have trouble seeing this. From where I sit, core inflation (which is what the ECB targets) hasn’t really budged much since 2015. It averaged +0.8% yoy in 2015 and 2016, and in 2017 and so far in 2018 it’s averaged +1.0% yoy.
Furthermore, since that time stock markets are down, EM are suffering more, oil prices are up, and the Brexit fiasco has gotten worse. Italy has appeared as a major headache for the EU. And most indicators of growth, such as the PMIs, have continued to slow. No one thing really stands out to tip the ECB’s hand, but it seems like the risks are mounting at the same time as core inflation isn’t quite doing what Draghi said he thought it would. Headline inflation may have risen back to the target level, but that’s probably just due to higher oil prices, which is a negative for the Eurozone economy as a whole.
In short, the market will be listening closely to what Draghi has to say. Is he still optimistic? Has the ECB decided to start normalizing policy, or are they still waiting for more concrete signs from inflation? That will be the key take-away from the ECB meeting.
Elsewhere, everyone is still trying to figure out what’s likely to happen with Brexit. I have no inside track to that one, I must admit. I personally can’t think of how they will satisfy everyone, yet I think that at the end of the day, nobody wants this to be a disaster, so they will probably all find some face-saving way to kick the can down the road, which historicallyi has been the way the EU deals with intractable problems that are politically poisonous – vide Greece, 2011.
Friday morning, Japan announces the Tokyo CPI for September. But my guess is JPY will be much more dependent on stock market movements than on Japan’s economics.
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