Inflation takes centre stage

The international calendar is crammed this week with key inflation data in the UK, US and China, and preliminary GDP estimates across most of the Eurozone and Japan. The reverberations of Japanese Q4 GDP will be watched with particular interest as markets eye the likelihood of a move back into negative territory.

Otherwise, inflation looks set to dominate, with the Bank of England’s Quarterly Inflation Report (Wednesday) coming on the heels of key CPI/RPI figures the day before.

This week’s Inflation Report could well prompt renewed volatility in sterling interest rate markets. We expect Governor King to provide a rigorous defence of the Bank’s policy to look through the first round effects of a supply shock, remaining focused on the mediumterm outlook for inflation. Indeed, King gave the clearest exposition of this policy in a recent speech. Yet inflation developments will complicate this message. The acceleration in inflation above November’s forecasts will necessitate an increase in the short-term inflation profile this time (King mentioned a peak of between 4- 5%) and a likely further skewing of upside risks. Yet we will watch the 2-3 year portion of the projection as most relevant for policy. We expect the median forecast to remain below 2%, although it will be important to note the differences between the Bank’s alternative forecasting scenarios (constant and implied market rates) for any implicit validation of the relatively rapid pace of tightening currently priced into the curve. We expect King to justifiably stress the uncertain outlook and, combined with a rise in upside inflation risks, we think this could spark further selling in interest rate markets. Barring signs of second round effects, we doubt key MPC members will be comfortable tightening policy before clearer evidence that the economy is able to withstand the sharp fiscal tightening ahead.

Our outlook suggests the sterling yield curve will drop before the next Inflation Report. Sharpening market focus before the event, January’s consumer price inflation numbers are due on Tuesday. Petrol prices rose sharply on the month and we expect
food price inflation to rise further, instantly adding 0.2% points to the headline rate. Thereafter, January’s inflation number will be largely determined by how much of the 2.5% point increase in VAT (to 20%) was passed on to consumers this year compared to last. National Statistics estimated that less than a third was passed through in January last year (adding 0.4% points from a maximum 1.5%). Though firms may have been less able to absorb a second hike, we think that a weak consumer background and higher levels of stocks (reflecting shopping disruption in December) will have led stores to discount more aggressively in January, forestalling much of the VAT pass through. Indeed, the BRC noted only modest increases in non-food retailer pricing. We forecast CPI inflation rising from 3.7% to 4.0%.

This could well leave January’s retail sales providing the biggest market surprise of the week. Sales at this time of the year are always shrouded in uncertainty given the scale of expenditure and seasonal adjustment. Drawing conclusions on spending trends from this month’s numbers will be risky and Governor King has stated that one waits until Easter to know
what happened at Christmas. But snow (again!) adds to the complications. Many expect the post-snow rebound to have lifted sales this month and John Lewis reported a 38% annual rise in department store annual sales in the first week of January. Indeed the BRC reported a jump in total sales growth to 4.2% from 1.5% and early consensus forecasts look for a 0.5%
rise this month. However, snow also affected January’s sales last year, contributing to a 3.5% monthly drop.

Against this weak comparison, annual sales growth should have soared, particularly as accelerating prices (for value measures) and a rebound in vehicle fuel sales should have further supported the number. Accordingly we cannot make a compelling argument for monthly sales growth and forecast a fall in total sales of 0.4%.

Such a fall would suggest a contraction in quarterly sales and underlines the plight of domestic households. Indeed, news on the labour market, also due this week, looks set to make this point further. We expect earnings growth to slow to 2.0% in the three months to December, with quarterly unemployment up 25k and employment falling. The weakness of the household sector is one of our key concerns for 2011 - alongside the impact of sharp fiscal tightening. It is a consideration of these downside risks to activity that we think makes monetary policy tightening now both undesirable and unnecessary. Markets are still pricing a Bank Rate of 0.75% in May and 1.25% by end-year. While we have regularly emphasised our different view, we think that this week’s Inflation Report could mark the height of this speculation and expect data from Friday’s sales onwards to be increasingly constructive for interest rate markets.

The focus internationally will also be on inflation this week. Against the backdrop of rising commodity prices and aggressive monetary stimulus, the annual rate of Chinese inflation is expected to have risen to 5.3% in January. If realised, this would be the highest rate since July 2008. If, as we expect, Chinese inflation pressures continue to build over the coming months – annual CPI is forecast to remain above 5% until the spring – the PBOC is likely to come under pressure to raise rates further, or to allow a faster pace of currency appreciation. Wholesale prices in India are also expected to post a further rise, intensifying pressure on the RBI tighten monetary policy further as well.

Price gauges in the US, however, are likely to draw only passing interest this week, as it is generally accepted that spare capacity remains abundant. Moreover, the Fed is already acting to ensure that inflation does not fall too low, so any rise in headline inflation is likely to be viewed, at least in part, as a positive. We look for a modest rise in the annual rates
for both headline and core US CPI in January, albeit to just 1.7% and 1.0% respectively. The minutes of the January FOMC meeting, released on Wednesday, should underline that QE2 will progress according to plan. It is the employment data rather than inflation that will ultimately dictate how quickly and aggressively the Fed reverses its policy course.

US activity data should draw more attention, headed by January retail sales (Tuesday). We look for a seventh consecutive monthly gain (+0.8%, ex autos +0.6%) as consumers respond to the improving economic backdrop and the recent fiscal boost. Fed manufacturing surveys from NY and Philadelphia are expected to show buoyant conditions in February, while we believe official data for January industrial production could trump expectations. Housing starts could also provide an upward surprise after falling to the lowest level since October.

In the Eurozone, financial markets still await workable proposals for a permanent mechanism to resolve any future euro sovereign debt crises. And now they are being distracted by the issue of who succeeds Jean-Claude Trichet as ECB President when his term expires in October. But this week presents an opportunity to re-focus on economic data, where the main highlight will be Tuesday’s preliminary estimate of Q4 euro area GDP. Our forecast stands at +0.4% quarter-on-quarter, for an annual rate of 2.1%.

In Germany, we see a +0.6% pace of expansion inferred from the Bundesbank’s 2010 full-year growth estimate of 3.6% released back on 12 January. This would seem a reasonable outturn given the severe winter weather conditions during the quarter. Indeed, we suggest risks to Germany’s Q4 GDP number to be skewed to the upside. There continue to be encouraging signs of a pick-up in domestic demand in Germany – supported by relatively robust labour market conditions - alongside the traditional driver of activity, net exports. GDP data are also published for France and Italy, where our forecasts stand at +0.4% and +0.3% quarter-onquarter, respectively.