Near-term upside risks remain: We still see upside risk to our near-term inflation forecasts: inflation expectations remain elevated; there is some evidence of a pick-up in wage settlements since the start of the year; and we still see particular upside risk for food and clothing from higher commodity prices. However, we still think that, looking through ‘special factors', underlying consumer demand is weak. This may weigh on prices over the coming months if, for example, retailers overstock.
Implications for the MPC: The BoE appears prepared for relatively high inflation in the near term (the Inflation Report again warned of up to 5%) and the upward movement in these data is largely attributable to "special factors". However, inflation at current levels (2.5pp above the inflation target) is uncomfortable for the MPC. We continue to expect the first rate rise in August, contingent on a pick-up in wage growth over the next few months and where current BoE forecasts appear to us to be consistent with at least one rate rise this year (see Inflation Report: Sticking to Our August Rate Rise View, May 11, 2011). But we also continue to expect GDP growth to disappoint, leaving the risks skewed towards a later first rate rise.
As some ‘temporary' factors such as the large rise in petrol prices roll out of the year-on-year comparison, we expect inflation to begin to drift lower at the end of 2011. However, we continue to think that inflation will not decline below target in 2012. We expect wage growth to rise, we think spare capacity is relatively limited and our Global Economics team sees global inflation risks as being skewed to the upside.
There are two main sources of medium-term upside concern: 1) That the high current inflation numbers become ‘embedded' through high inflation expectations and wage growth; and 2) That some of the import price/commodity pressures will linger. Judging by MPC communications, both 1) and 2) are a concern for some on the MPC. Global inflation pressures are one reason why we remain concerned about high inflation outcomes in the longer term and the potential for the 2% target to become untenable.
Key Factors and Assumptions Affecting Our Central Inflation Forecasts
Growth: We expect GDP growth to be sluggish over 2011 (1.2%), picking up in 2012 (1.8%). Although spare capacity should dampen inflationary pressures, we think that the amount of spare capacity has already reduced significantly.
Interest rates: We expect the BoE to keep interest rates on hold until 3Q11, ending 2011 at 1.0% and 2012 at 2.0%. Rising interest rates increase the mortgage cost component of RPI and help to keep RPI inflation above CPI inflation over the forecast horizon. For more detail on our monetary policy outlook see page 8 of The Gilt Edge, May 4, 2011.
Oil: We have assumed that Brent oil prices have now peaked and will drift lower over the remainder of the forecast horizon, in line with futures prices. In sterling terms, using our currency team's GBP/USD forecast, the picture is very similar, but with some small price rises in 4Q11. For details of the currency forecast, see the FX Pulse.
Main Changes over the Past Month
Upward surprises not fully reversed: April CPI inflation surprised on the upside by 0.4pp compared to our forecast (and by 0.6pp compared to our forecast a month ago). We have assumed that not all of this upward surprise is reversed (i.e., we have assumed that some is about more than weather/Easter timing effects). This adds around 0.2pp to our average 2011 CPI inflation forecast.
Decreases in oil futures: Over the last month, oil futures have fallen. This takes off around 0.1pp from our full-year 2011 CPI and RPI inflation forecasts.
We have assumed 6% across-the-board increases in gas and electricity prices in late summer/early autumn: This adds around 0.1pp to our CPI and RPI inflation forecasts. Current prices look more consistent with a 10% rise in electricity and gas prices in the view of our Utilities team. However, in UK Commodities: More Downside to Come? May 16, 2011, the team also highlights downside risks to UK energy prices and notes that prices have fallen around 8% in the past month. We have effectively built in some of this downside risk into our forecasts.
Key Risks
Specific risks in clothing inflation: Upside risks stem from higher input costs, but there are some downside risks if consumer spending is weaker than retailers expect (resulting in over-stocking and discounting). Currently we anticipate 1.4% average CPI clothing inflation over the remainder of 2011. RPI inflation in clothing and footwear is already 10.9%Y (1.3%Y in CPI).
Higher food price inflation: We continue to worry about the potential for higher food prices in the near term after earlier commodity price increases (especially wheat).
Electricity and gas prices: In a recent note, the Utilities team highlights downside risks to UK energy prices.
Higher inflation expectations and wage demands: A significant upward drift in household inflation expectations and wage settlements would raise the risk that current high inflation outcomes have serious implications for future inflation. There is evidence that medium-term household inflation expectations have drifted upwards since the start of the year. We expect wage growth to pick up further in 2011: 1) the public sector wage freeze won't weigh on overall earnings growth quite as much as some expect (see UK Labour Market: A Second Softening, November 25, 2010). 2) Consumers will likely have taken a cut in real incomes in 2010 and employees may feel that, after helping their companies work through tough times (e.g., taking unpaid leave), higher wages are justifiable. 3) Inflation has been above the 2% target for most of the past two years. Average earnings growth data, so far, suggest that there is little to worry about though. Regular pay growth was 2.2%Y in February (three-month moving average) (average since 2001: 3.5%Y). In tomorrow's release, for March, we expect pay growth to have remained at 2.2%Y.
After months of an uptick in inflation, Brazil is likely to see an improvement on the horizon. In the coming months, we expect monthly inflation readings to ease: averaging 0.20% between May and August, in contrast with an average reading nearly four times higher in the first four months of the year. While much of the improvement may be linked to seasonal factors, we suspect that the pressure on Brazil's central bank to act more vigorously on rates should ease as well.
The turnaround in inflation in Brazil might seem surprising. After all, at the start of the year, there was growing concern that Brazil's inflation picture was threatening to spiral ever higher. And we still hear concerns around emerging markets that inflation, particularly food inflation, is a major concern. What has happened in Brazil?
'Tis the Season
Part of the improvement in Brazil's inflation dynamic is simply seasonality. Favourable weather tends to help food prices, while the beginning of the sugar cane harvest season helps to bring down ethanol prices and, finally, clothing prices at this time of the year tend to come under pressure to move lower, thanks to sales.
But the emergence of seasonal downward pressures on inflation is still welcomed. After all, just a few months ago many contended that Brazil's inflation dynamic was at risk of moving steadily higher. It's easy to see why many were alarmed: monthly readings rose from 0.45% in September to 0.81% in January. At the time, we argued that the early readings - largely concentrated in a temporary upswing in food prices in general and in beef in particular -were not a good predictor of how inflation would develop in 2011 (see "Brazil: Misdiagnosing Inflation", This Week in Latin America, February 21, 2011).
The bulk of the inflation at the turn of the year was concentrated in a handful of food items and, within that handful of food items, one item alone was the principal culprit - beef. Beef alone accounted for nearly half of the acceleration in inflation in the 12 months ending in January 2011. In our calculations, beef accounted for 68bp of the 144bp increase in inflation between January 2010 and January 2011. And most importantly, the uptick in beef had little to do with global grain prices - cattle in Brazil tend to be largely grass-fed. Instead, supply issues - as well as healthy demand - helped to exaggerate a seasonal uptick and made it the most important, albeit temporary, driver of inflation.
Since the turn of the year scare, expectations have peaked. Despite the uptick in 2011 expectations, expectations for the next 12 months peaked in January near 5.5% and have declined slightly since then. Moreover, breakeven inflation in the past month has come down from 6.1% to around 5.4%.
This year, the improvement in food prices from better weather may look even more remarkable, given the unusually bad weather at the beginning of the year. Brazil had some of its worst floods in Rio de Janeiro and São Paulo - that account for 50% of the CPI - early in the year, causing produce to increase by 30% between January and March. Simply a return to more normal weather should help food prices to fall by 5%.
And the seasonal improvement is not limited to food. Although Brazil's fuel price uptick coincided with the global oil prices increase, its fuel prices uptick was influenced by the sugar cane offseason, which has now passed. This reversal alone should contribute with -25bp in the coming two months.
Fiscal policy and credit figures should also bring positive news for the inflation fight. March's fiscal number showed that the government is willing to sacrifice the infrastructures budget in order to rein in expenditure. Although revenues saw a significant increase in March (up 18.9%), expenditures decreased by 7.2%Y. This suggests a strong commitment that we do not expect to fade in the next few months. Also, as macro-prudential measures are absorbed by the system, we expect credit growth to slow down, also helping to curb domestic demand.
Of course, not all is well on the inflation front in Brazil: despite the improvement in monthly readings, yearly comparisons are still likely to deteriorate. Given the very low numbers registered in June-August 2010 (average 0.02%M), even if inflation is as low as we expect, compared to the previous year there is likely to be an uptick. The central bank has long argued that this was due to base effects, and has discredited this as an issue of concern. We believe that year-over-year readings could drift all the way to 7.1% in August. As the beef price shock that started in September 2010 fades out, we should see declining annual numbers. Further, looking at year-over-year readings can be misleading, especially if monetary policy actions have been taken. Given that monetary policy works with a six-to-nine-month lag, the initial actions taken in December should be fully seen in August.
The Wage Challenge
The problem is that even if we argue that year-over-year numbers can be misleading, they cannot be completely ignored by policy-makers. One of the more expensive inheritances from almost 20 years of hyperinflation is an indexed economy with backward-looking economic agents. Nowhere is this seen more clearly than in wage negotiations, which are still viewed as an opportunity to regain purchasing power lost in the previous 12 months. The unfortunate coincidence is that some important wage negotiations are set for September, exactly when annual numbers are peaking.
Even if important wage negotiations did not happen just around the inflation peak, indexation would still be a challenge to address. Indeed, recently some government officials have been looking at utility company backward-looking contracts as the culprit of Brazil's slow convergence to lower inflation. The difficulty is that utilities have not been the strongest driver of inflation. Instead, one of the biggest drivers of inflation has been wages that heavily influence service prices.
This strong pressure coming from the labour market can in turn be attributed to overheating demand. For more than a year now, domestic demand has been outpacing supply (the Growth Mismatch): while it is possible to import tradable goods, the same does not apply for labour and services. Hence, with buoyant domestic demand outpacing labour supply, inflationary pressures are being created. The worrisome bit is that we are concerned that as long as the terms-of-trade shock remains in force, domestic demand will likely continue to outpace supply.
The real danger here is that the service component of inflation is not likely to reduce its pressures in the next few quarters. In order to achieve that, labour markets would have to undergo a correction - not a scenario that we expect to be induced by policy-makers. Our concern is that Brazil is likely to face persistently higher service inflation.
Does this imply higher overall inflation? Not necessarily. Services are only part (24.6%) of overall IPCA, and even if service prices continue at their current pace, it is hardly a sign that inflation is set to move higher. As long as the other components - such as food prices, government-controlled prices and tradable goods - are well behaved, inflation should, although being high, remain in check.
The perverse dynamic is that, given that wage negotiations are backward-looking, higher inflation this year creates even more pressure on service prices in 2012. This implies that a supply shock in one year (such as beef prices) is more persistent. Indeed, our work in analysing services and headline inflation suggests that the causality runs from headline numbers to service prices and not the other way round.
We understand that breaking the indexation cycle is a hard task, but we also believe that more could be done by policy-makers. The recent minimum wage rule is likely to make breaking indexation that much harder. And we remain concerned that Brazil's fiscal stance is likely to continue to challenge its inflation dynamics.
Based on these factors, we are revising our 2012 IPCA forecast to 5.3% (from 4.8% previously). Although we do see domestic demand slowing down, we do not expect the slowdown to be large enough to reverse Brazil's current service inflation dynamic. And although our forecast for 2012 is above target, we are not forecasting that the central bank will raise rates beyond 12.50% in the coming months.
The central bank is likely to argue that its forecast will show a faster convergence path in 2012. But we are concerned that Brazil's current inflation dynamic - notwithstanding the seasonal improvement we are likely to see in the coming months - is stickier and should make the inflation convergence path in 2012 more difficult.
While the total output of the economy is growing at a slower pace for three quarters now, making it possible to argue that the output gap has closed, the labour market is showing few, if any, signs of cooling down over the same period. We are concerned that simple output gap measures pointing to lower inflation can be misleading. Unlike most periods of high inflation in Brazil where real wage growth turns negative, this time round wages are running above inflation. We suspect that this will make for a more persistent inflation problem in 2012.
Bottom Line
We expect to see an inflation improvement in the next few months - welcome news after fears earlier in the year that inflation would move even higher. But beware of getting too upbeat: while Brazil's inflation may not be spiraling ever higher, it is far from being resolved. Indeed, the stickiness seen in wage negotiations is likely to mean that Brazil lives with a more persistent inflation problem than many have expected. This should set up for a resumption of pressure on the central bank later in the year after the upcoming lull.
Read Full Article »