With today’s raft of service PMIs, there are more signs of stabilisation in the global growth cycle (both China and European indices bounced). There remain lingering concerns around the manufacturing cycle, especially in Europe, but the larger issue could be falling inflation. Indeed, US inflation expectations (as priced by rates markets) plunged towards the end of last year, and while they have bounced since, they have yet to recover to the levels seen before the plunge. More recently, Euro-area inflation expectations have fallen sharply.
Actual inflation data in both regions have also fallen with US core PCE at 1.8% and Euro core CPI at a paltry 0.8%.When we look at trends in these series we find they are persistently below the 2% inflation targets of their central banks (see first chart). This poses a dilemma for both the Fed and ECB.
For the Fed, their fear would be a “Japanification” or “Eurofication” of inflation expectations and so are increasingly talking about targetingaverage inflation rather than just spot inflation. This suggests that there is scope for the Fed to turn even more dovish as they would comfortably tolerate upside surprises to inflation. Clearer signals of the beginning of Fed easing would likely be dollar negative especially against the euro and yen.
For the ECB, policy is already loose (see second chart). Their challenge will be to exert even more easy policy with policy rates in negative territory and bund yields at zero. The way out could be more generous tLTROs or for governments to deploy fiscal stimuli. Either course could end up be more positive than negative for the euro as the former would help narrow peripheral spreads and latter would boost growth.
While policymakers prevaricate over next steps, the dollar is stuck in a range, but our bias remains to eventually see dollar weakness.
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