Inflation fears trump signs of economic slowdown - for now

Although last week’s MPC meeting passed without event, growing nervousness over the UK rate outlook continues to weigh heavily on sterling rate sentiment. The Dec-11 short sterling contract has fallen close to 40 ticks since the start of the year, as short-term inflation fears trump growing signs of an economic slowdown. After last week’s mixed external trade and industrial production data, we expect Q4 GDP growth (due 25th Jan) to slow to 0.2%q/q. Still, against the backdrop of surging pipeline price pressures (input prices rose 3.4% in December), it appears the market is not, for now at least, attaching
much importance to this.

December’s CPI release on Tuesday will do nothing to allay these fears. A number of factors look set to drive this month’s figures higher, including domestic utility tariff hikes; higher petrol prices; and ongoing food cost pressures. While strong food price increases last year will cushion some of this month’s rise, we fear a snowaffected jump in seasonal costs, as seen in Germany, supplementing ongoing non-seasonal trends. Energy price rises see no such offsetting base effects and look set to add close to 0.3% points to this month’s CPI rate.

We forecast CPI inflation accelerating to 3.6% in December, its fastest pace since a Budget affected April. The MPC will find only faint solace that ‘core’ inflation looks set to inch higher to 2.8% (from 2.7%). Inflation expectations will be fanned by the increase in the RPI measures of inflation to 4.9%, a 6-month high. Nor is December likely to mark the peak in this upswing. The increase in VAT in January, along with further food and energy price increases likely in the first few months of 2011 look set to push the headline rate towards (but short of) 4.00% in Q1 2011.

An outturn in line with our forecasts would likely cause short-term rate markets to come under more pressure fearing a reaction from the Bank of England. Yet we maintain that such fears are overdone, with the rise in inflation likely to be temporary.

Indeed, with the prospect of soft labour market and retail sales figures later in the week, any CPI inspired sell-off
may be short-lived. Having posted strong growth earlier in the year, there has been a noticeable softening in the labour market over the past six months, with total employment in the three months to September dropping by 33k - its first 3-mth decline since January. Although the employment component of the manufacturing PMI continues to improve, the PMIs suggest employment in construction and services continues to contract. Overall, we forecast claimant unemployment to have risen by 7k in December (market consensus: 0.0k).

Although the 2011 pay round gets underway in earnest towards the end of Q1, this week’s labour market pay data will be watched closely for “second round” effects. Although there has been a slight upward creep in private pay growth over the past year, this has been broadly offset by a slowdown in public sector wage growth.

Overall pay growth is currently running at just over 2% and we forecast the headline and ex-bonus rates to remain unchanged this week at 2.2% and 2.3%, respectively.

These are well below the rates required to trouble the medium-term inflation outlook. Turning to retail sales, we are surprised that the consensus forecast this week isn’t lower. The market is looking for sales (exl fuel) to have dropped by 0.2% m/m in December. Although monthly retail sales out-turns are notoriously volatile - since last March, the average error of the market’s forecast is 0.5%m/m - the downside risks to this month are substantial. Firstly, the BRC survey reported that
annual high street sales slowed from 2.8% to 1.5% last month; secondly, there were widespread reports of price rises, particularly in food and energy; and lastly, sales for many companies were hit hard last month by the worst weather conditions on record. Putting this together, our model suggests sales (ex fuel) dropped 1.0%m/m, with sales (incl fuel) down more sharply (f:-1.4%m/m) due to price rises and weather interruptions.

Elsewhere, this week’s raft of Chinese data has the potential to unsettle global markets with Q4 GDP and December PPI and CPI all released on Thursday. With industrial production and fixed investment slowing, annual GDP growth is forecast to have moderated from 9.6% to 9% (market consensus 9.4%). If realised, this would be the lowest outturn since Q2 2009. Early signs
of a slowdown are partly attributable to the tightening in Chinese monetary policy, as the PBOC seeks to quell incipient inflation pressures. Last week, the central bank raised reserve ratios by 50bp - the fourth such increase in two months.
Nevertheless, with interest rates at still historically low levels, and policymakers having allowed only limited currency appreciation, there is a risk that the economy fails to slow sufficiently to prevent inflation building.

While we look for consumer prices to have eased in December to 4.8%, from a two-year high of 5.1% in November, higher US dollar denominated commodity prices are likely to be reflected rising pipeline pressures, with Thursday’s annual PPI forecast to rise to 6.4%. If these pressures continue to build, policymakers could respond with more aggressive rate hikes and,
potentially, a swifter pace of remnimbi appreciation. In this regard, Premier Hu’s state visit to the US this
week will be watched with interest. Since the removal of the remnimbi’s ‘soft peg’ last June, official meetings involving China have been preceded by a quickening in the pace of remnimbi appreciation. Markets will be watching closely for a similar gesture this week.

In the eurozone, the economic data and events calendar is fairly light. The main focus will be on the German IfO business climate and ZEW surveys. Both are expected to underscore the continued recovery in the eurozone’s largest economy, with the IfO business climate index forecast to rise from 109.9 to 110.5 in January (consensus 109.9).

In the US, this week is dominated by a variety of US housing market indicators, beginning with December housing starts scheduled for Wednesday. The underlying trend has been essentially flat for much of the past two years - our forecast stands at 540k units.
Existing home sales data for December are released on Thursday. If anything, these have staged a recovery since the decline following the expiry of the homebuyers’ tax credit last year. Nonetheless, we expect the level of sales to remain historically low at 4.85 million.

Other key US indicators include the Empire and Philadelphia Fed surveys. These have exhibited somewhat differing trends in recent months (the Philly Fed survey being relatively more upbeat). Finally, leading indicators data (a reasonable gauge of GDP growth) are published on Thursday.