Inflation In Eurozone and US

Inflation or deflation? Well, expectations may drive it ...

The quantitative strategy team at Societe Generale wrote in the note yesterday:

Global markets have moved in harmony over the past few weeks. With no significant dislocation, the drop in the dollar and the equity markets' upbeat performance pretty much sum up the action.

Rising US inflation expectations were in part responsible for these moves. We highlighted two weeks ago that inflation expectations were undervalued when compared to buoyed equities and increasingly expensive precious metals. After leading two weeks of sustained rally, long-term inflation expectations are now fairly priced.

Despite the rise of market inflation expectations, our aggregated inflation risk factor has been trading in a relatively tight range since June 2009 after periods of inflation fears (summer 2008) and deflation worries (September 2008 till March 2009). So we remain between a high- and a low-inflation regime: the debate on the future shape of the recovery therefore remains open.

Click on chart to enlarge, courtesy of Societe Generale.
Interestingly, the economists at BNP Paribas looked at the ECB's assessment for inflation in the Eurozone yesterday:

With broad money growth collapsing and excess capacity likely to exercise downward pressures on wages and prices for another while, the ECB’s conclusion that risks of deflation in the eurozone are very limited extensively relies on the observation that inflation expectations are ‘well anchored’. But available measures of inflation expectations have a number of limitations:

• First, at the current juncture, they are providing mixed indications, with business and consumer surveys (which however have a shorter horizon than other measures) decisively more downbeat than expectations derived from market or analysts’ surveys;
• Professional forecasters’ inflation expectations are partly conditional on the assumption that the ECB will do what it is needed to comply with its mandate. Excessively relying on these expectations may lead the central bank to be complacent to possible shocks (‘paradox of credibility’);
• While useful to provide a rough guide to trends in inflation expectations, market-based measures are not necessarily a precise indication of market participants’ inflation expectations. In particular, it is very difficult to disentangle the risk premium required to hold inflation, following the impact of the financial crisis; and
• Last but not least, inflation expectations tend to respond to actual inflation. Persistently low inflation rates (our but also the ECB’s expectation over the next few months) could lead to a sudden fall in inflation expectations such as that feared by Mr Kohn in the US. We see this as the predominant risk at the current juncture.

Against this backdrop, the ECB’s current assessment that expectations are ‘well anchored’ may well be challenged over the next few months, revealing that risks of deflation are higher than currently suggested by the central bank.

But who knows? At the end of day forces of nature will win the wishful thinking ... Will currency help to reflate the US?