10 April 2022 Europe | Global | Monetary Policy & Inflation | US

CPI to Start Showing Impact of Ukraine Crisis

By Dominique Dwor-Frecaut and Henry Occleston
7 min read

US Key Points

Fed speakers next week likely to support 50bp in May but remain equivocal for the remainder of the year.
CPI to clear 1.2% based on gas price increase.

Europe Key Points

Jump to Europe section

The first round of the French Presidential Election takes place on Sunday.
No policy change is expected from the ECB on Thursday.
UK GDP, CPI and labour market data is the main draw in data. It should all support BoE hawkishness.

US

Fed

The most important speech of the week was Brainard’s which did not seem very hawkish to me, since she validated current market pricing is still counting on factors outside of Fed policy to bring down inflation (see Immaculate disinflation risks a protracted recession) and is prepared to wait until end year for those to manifest themselves. She did prepare the market for a very aggressive QT announcement in the minutes (see Brainard speech has more bark than bite).

The most important part of the minutes was the QT announcement, which was more aggressive than I expected:

QT will start ‘possibly’ in May.
As in 2017-19, QT will be implemented through reinvestment caps, but higher this time: about $60bn for Treasuries and $35bn for agencies, to be phased in over about three months.
When Treasury principal payments are below the cap, T-Bills will be redeemed up to the cap.
With MBS redemption likely to run under the cap, outright sales would be implemented ‘after balance sheet runoff was well underway’. (See Fed Minutes: The New Info Is Mainly About Quantitative Tightening)

I have changed my view on the Fed terminal rate and now expect it to be close to 8%. The 2 key reasons are:

In every tightening cycle since 1965, the cycle ended when the FFR got close to the Taylor rule FFR and the Taylor rule FFR is currently 8%.
The Fed inflation model, the expectations augmented Phillips curve has already been falsified by the data and the concept of R* has a very weak logical and empirical basis as repeatedly stressed by the BIS and many others before. (Please see Terminal Fed Funds to approach 8%)

Overall, this week’s Fedspeak is consistent with my new view as it suggests the Fed is not ready to hike by more than what the market expects i.e. it is likely to slide further behind the curve.

As of this writing, speakers next week are Bostic, Bowman, Waller, Evans, Brainard, Barkin, Mester and Harker and I expect them to validate 50bp in May.

Data

This week’s services PMI was in line with expectations i.e. well below the peak of November 2021. For all the talk of new variants COVID-related hospitalizations continued to decline this week.

The most important data point of the week will be the CPI. I agree with the market consensus of a 0.7% difference between headline and core CPI as the increase in gas prices in March was one of the largest on record. Despite the continued decline in prices at the Manheim used car auction there is a good chance that core MoM CPI will be above 0.5% as inflationary pressures have become widespread. So, 1.2% MoM could easily get exceeded. In addition, the full impact of the Ukraine crisis and of China’s continued zero Covid policy on core goods prices won’t be felt for a few months.

Other key data includes:

U Mich consumer confidence, which the consensus expects to fall relative to February and I agree. A recent paper by ex-BOE MPC Blanchflower argues that drop in consumer confidence of the magnitude we have seen suggest a recession, which is also what our recession probability model and our Beige book sentiment indicator are pointing towards.
Retail sales: the consensus expects a limited pickup, 0.6%, relative to February’s 0.3%. I don’t disagree but even this modest pickup will be well below the expected mom CPI increase.
Small business optimism: the consensus expects a decline and I agree.
PPI, import prices, business inventories, NY Fed Empire survey, IP, TIC and unemployment claims.

Events/Political Developments

The administration announced that it would extend the moratorium on student debt repayments, first enacted in March 2020 as part of the CARES Act, through 31 August.

Links to New York Fed POMOs/TOMOs: Repos, Treasury, MBS, CMBS

Europe

Market Underpricing Le Pen Risk

The first round of the French presidential election will take place on Sunday. The focus right now is on how well Le Pen performs. In this regard, the first round may not actually be that informative, as tactical voting is likely to cause a skew (an out/underperformance on Sunday does not necessarily reflect what will happen in round two). Polling right now points towards a Macron/Le Pen rematch in the second round, but there is a tail risk that tactical voting on the left might give Melenchon the momentum to slip into round 2 – it’s happened before.

For now, we see the market as underpricing the risk of a Le Pen victory. It’s still a tail-risk, but it’s not a small one. If the weekend sees a performance in line with polling, and a confirmation of a Macron/Le Pen head-to-head, then we would expect a knee-jerk weakening in French assets come next week.

No Change to ECB Policy

The ECB is not expected to change policy at this meeting. Comments on Friday from ECB sources pointed towards the creation of some new “crisis tool” to respond if spreads were to blow out. While it will be impossible to draw any solid conclusions until more details emerge, from our perspective this points towards the ECB attempting to assure the market that a jump in yields (be it from the wind down in APP, or from the French election) will not in itself delay the path to normalisation. In other words, to assure them that a periphery blow-out alone will not cause an extension in APP beyond the path laid out, or delay the path to hiking.

This can be taken as mildly hawkish, but does not suggest to us any substantial change in policy direction, speed of hiking or of APP winddown. ECB President Lagarde will doubtless be pressed for details on this at the presser on Thursday, although it may be that for now the ‘mechanism’ is simply rhetoric designed to pre-empt market fears.

Otherwise, the ECB will probably want to stand pat, remaining data dependent for the time being. We expect that the lack of wage growth second round effects, and the prospect for CPI to trend down in the coming months should allow Lagarde to continue to look through the near-term inflation spike.

UK-Centric Data

Data is UK-focused this week, with February GDP outturn on Monday, March labour market data on Tuesday, and March CPI on Wednesday. GDP is expected to support evidence of a stronger than previously anticipated Q1 economic backdrop, supported by manufacturing and services, with weakness in construction.

Unemployment data should point towards continued tightness in the labour market, while wage growth remains elevated vs historic rates around 4% y/y for regular pay. This would continue to add support for BoE hiking to counter second-round effects.

UK CPI is expected to have risen further to 6.6% y/y in March in the headline reading and see a core reading above 5%. The peak is expected to come in April with the Ofgem price rise. The big question is whether this rise falls back quickly or continues to support inflation levels.

In sum, data this week should all add to BoE hawkishness, although the market is already pricing in probably too much in this regard.

Other G20 Countries

This week the BoC and RBNZ are holding their policy meetings, and both are expected to hike, the RBNZ by 25bp and the BoC by 50bp. The BoJ Kuroda is speaking.

Key data releases include China’s GDP, IP, retail sales, investment, credit and trade balance.