Economic Outlook: Long-term Inflation Expectations in Focus

This week's highlights

There is now strong focus on expectations about inflation for the long term after Mr Bernanke of the Fed announced that the Fed will aggressively curb any rise in the long-term expectations about inflation.
The long-term inflation expectations are important because wage earners will demand bigger wage rises and investors higher yields to maturity if their inflation expectations rise. This because we all, wage earners and investors, wish to protect the purchasing power of our wages and assets as a minimum. If consumer prices rise faster than wages or yields, their purchasing power will be undermined. Wage earners and investors may accept this state of affairs for a year or two, but not in the longer term.
If the long-term inflation expectations begin to rise, they will spark both higher market rates and higher wage claims. Particularly the latter of the two is problematic, because it may start a so-called wage-price spiral which involves that wages and prices spur each other on as was the case in the 1970s.
The central banks therefore fear a rise in the long-term inflation expectations, which will become a focal topic. Unfortunately we cannot measure the long-term inflation expectations direct, but there are a number of indicators like inflation-indexed bonds and opinion polls among economists and consumers. These are shown in the chart below, which shows that most measurements of inflation expectations are still stable at around 2.5%. The measurement made by the Uni of Michigan which indicates consumers' expectations of inflation five years from now has, however, climbed to close to 3.5%.
In our opinion, the price increases are mainly due to rising food and energy prices and to the weak dollar, i.e., mainly external factors. The domestic inflationary pressure in the form of wage rises, productivity growth and demand pressure point rather to falling inflation. We therefore do not expect to see the long-run inflation expectations rise markedly.
Fed's Rosenberg: these past fifty years there has been a tendency for inflation to be lower after a recession than before it.
The US: Long-term inflation expectations

This week's other highlights

• The US: sentiment indicators for the construction companies, producer prices, and home construction
• The euro zone: consumer prices
• Germany: ZEW
• The UK: consumer prices, minutes of the monetary policy meeting at the BoE

Monday

The US: tendency survey of the construction companies in June

This index is interesting, since it gives an impression of the situation in residential construction - the sector of the economy which was definitely hit the hardest.
According to the tendency survey, the construction companies are downcast over the prospects for home construction. The index has remained comparatively stable at around 20 since last autumn. Since index 50 indicates unchanged home construction, index 20 indicates a sharp fall in home construction.
We expect home construction to bottom out towards the end of the year so that it no longer lowers the GDP growth rate by about a percentage point as has been the case for the past two years.
We expect that the sentiment indicator of the construction sector will remain very pessimistic, but there is potential for a fall in pessimism. For instance, construction firms have been a little more optimistic with regard to sales for the coming six months, and the index is often a leading indicator of trend changes. See further explanations under the section about residential construction in the US.

The euro zone: consumer prices - May

The consumer prices, as indicated by the preliminary data, showed a rising rate of increase. The inflation rate here rose from 3.3% to 3.6%. The statement also contained a statement of core inflation, which is a more important tool for evaluating whether the ECB's real fear of inflation for the medium term is as justified as indicated by the Bank in the risk of a wage-price spiral. It is chiefly the price of services which the ECB is focusing on at the moment. According to the Bank, its worst fears are for prices to rise too fast.

Tuesday

The US: producer prices - May

Inflation indicators have become important as the rising energy and food prices have pushed up inflation, and several Fed members have grown increasingly concerned about the risk of rising inflation. Producer prices are a little less interesting this month since consumer prices were already announced.
Lately, producer prices have risen relatively sharply. Also, the rise in energy and food prices tends to affect core producer prices. They have risen by 3% over the past twelve months which is the largest rise since 1991.

There have been signs of rising prices in the earlier stages of the production process. The prices of semi-finished goods and commodities (exclusive of food and energy) have risen faster than usual. It will be interesting to see if the price increases in the earlier production stages spill over into the price of finished goods. Traditionally, the spill-over effect has been relatively modest, and it has tended to hit with a bigger time lag. So the risk is not regarded as very big.
The ISM price index still indicates high price increases, and energy prices (oil, natural gas and gasoline), which are often driving total producer-price inflation, increased further from April to May. This signals a solid increase in producer prices in May. Many of the other commodity prices have shown some stabilisation in recent months, so the price pressure has abated a little. Moreover, capacity utilisation in the manufacturing industry has fallen somewhat below the historical average, which usually puts a damper on price rises in the manufacturing industry. In our view, core producer prices will therefore rise somewhat less than producer prices.

The US: building permits - May

Building permits are one of the most important economic indicators this week. The number of housing starts has fallen massively, as reflected by the fact that the number of building permits for single-family homes has fallen by no less than 64% since late 2005. This is the largest fall ever. New home sales fell by 62% over the same period.
The fall in building permits has, however, slowed. In late 2007, building permits fell by almost 60% y/y over three months, but this is now down to 15% y/y. The housing market is boosted by rising income and the fact that builders lower prices on new homes. Builders are, however, still pessimistic about sales.

Builders' stock of unsold homes is still very high, indicating a fall in residential construction. The number has fallen since mid- 2006, but mainly for homes under construction or projected. Builders' stock of completed homes did not begin to fall until the turn of the year. Hence, it is still a long way until builders' stock of unsold properties has fallen to a more acceptable level.
Therefore we expect a moderate decline in residential construction in May.

The US: industrial production - May

Industrial production is interesting, since it is traditionally highly cyclical and since it is followed by the committee responsible for deciding when the US is in recession.
Industrial production fell sharply in April. Part of the setback can be ascribed to a massive fall in the production of cars which was low due to a strike at a very large sub-contractor. Production fell in most other industrial sectors.

Generally, the manufacturing industry is in good shape with thick order books and a moderate increase in the inventory to sales ratio. The car industry and the housing-related part of the manufacturing industry are, however, in serious trouble.
We expect a small decline in industrial production for April due to the following signs: The number of working hours in the manufacturing industry fell by 0.2% in May, indicating a rise in industrial production of 0.1% according to our model.
ISM manufacturing was unchanged at 49.6, indicating largely unchanged production. ISM production rose to 51.2, indicating a small rise in production.
New orders in the manufacturing industry rose solidly again in April, but part of the rise covers price rises
The order books of manufacturing companies are very thick. They will act as a buffer against a temporary fall in the demand for industrial products.
The inventory to sales ratio rose, and normally this means that companies reduce their production.
Capacity utilisation in the manufacturing industry fell to 77.5% which is the lowest it has been since 2004 and somewhat below the historical average. Since there are prospects of a small decline in industrial production in our opinion, capacity utilisation will decline too.

Germany: ZEW - June

ZEW has for a long period signalled weaker growth in Germany. Also much weaker than we expect and what is justified by the economic performance. But we agree that growth will be weaker. We do not expect ZEW to rise in June but that it will be unchanged or a slight fall.

The UK: consumer prices - May

Inflation rose to 3% y/y in April and thus reached the limit when the central-bank governor must write a letter of explanation to the Chancellor (2% +/-1 percentage point). Inflation was mainly pushed up by rising electricity, gas, fuel and food prices. We expect that these factors will also push up inflation further over the next two months and thus result in one of the above-mentioned letters. Fees on mortgage loans and other bank services also pushed inflation up in April and contributed to an increase in core inflation (exclusive of energy, alcohol and tobacco) from 1.2% to 1.4%.

Rising inflation and not least rising inflation expectations are undoubtedly cause for concern at the Bank of England (BoE). The inflation expectations have (according to DG ECFIN) increased to the highest level since 1998, and a survey from the BoE, which has just been updated, shows that the Britons expect an inflation rate of 4.3% over the next 12 months against 3.3% in connection with the latest survey in February. In the latest inflation report, the central bank signalled clearly that at the moment it is more concerned about the inflation development than an expected slower growth rate. The BoE expects that inflation rises further from the current level, and that it peaks at just above 3.5% later in the year.

Wednesday

The UK: minutes of BoE meeting

The BoE decided to hold interest rates at 5% at the meeting earlier this month. It was not any major surprise that the BoE left interest rates unchanged after the latest inflation report and the minutes of the latest meeting had signalled clearly that the BoE was somewhat concerned about the inflation development. A more detailed explanation for the interest-rate decision will be provided in the minutes.
Although the growth indicators point to weaker growth, there are no indications that the BoE raises interest rates in the near future. In the latest minutes the BoE emphasised that slower growth (compared with 2007) is necessary if inflation is to fall down to the target again in the medium term. We expect that the minutes will send the same message.
The distribution of votes in the monetary-policy committee will also be revealed in the minutes. We expect there was relatively broad agreement behind leaving interest rates unchanged. It is very likely that Blanchflower voted in favour of a cut as he did in October last year. We do not expect that any member considered a hike.

Thursday

The US: jobless claims - week 23

Jobless claims are an indicator of how many new people join the unemployment queue. The claims are used as an indicator of developments in the labour market based on the following: the more claims, the weaker employment growth.
Jobless claims are also one of the best indicators of employment, and this week there is extra focus on the data since this is the week when the data for the job report are collected.

The US: Philly Fed - June

Philly Fed is one of the regional indicators of industrial confidence which are used as a gauge of how the economy is doing at state and federal level. There is a good correlation in the longer term between Philly Fed and ISM, although Philly Fed shows wider fluctuations than ISM in the short term. The development of Philly Fed has been much weaker than that of ISM in the past six months.
In addition to the overall index, focus will be on new orders, employment and the price index.

The UK: retail sales - May

Following a good start to the year with significant increases in the first two months, retail sales declined slightly in March and April. Although it is relatively small declines, it is the first time since January 2006 that retail sales have fallen for two consecutive months. Weak retail sales indicate that consumer spending is about to slow down as expected.

We expect that the weak development in retail sales continues in coming months due to a weak housing market and tightening of credit standards. However, surveys suggest a small improvement in May. The CBI index for retail sales rose in May (but the index still points to a decline compared with the same period last year), and the British Retail Consortium reported the largest increase in retail sales in four months. But please note that the monthly data are highly volatile
Jyske Markets - FX Research http://www.jyskebank.dk/finansnyt
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