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Inflation

02-Okt-2017
By BlackRock Investment Institute

The inflation outlooks in the US and eurozone stand in stark contrast. We explore the reasons and ramifications.

The inflation outlooks in the US and eurozone stand in stark contrast. Our BlackRock Inflation GPS points to core US inflation climbing back near 2% in coming months. See the Inflation’s demise exaggerated chart. Such an outcome should reassure US Federal Reserve (Fed) officials that this year’s inflation misses were mostly due to one-offs such as a price war in wireless data charges. We see the Fed pushing ahead with a rate rise later in the year given a strong labour market and steady economic expansion. We see further rate increases as likely in 2018, even with looming changes to the Fed’s leadership.

inflation-demise-exaggerated-chart

By contrast, we see core eurozone inflation stuck at much lower levels. That should keep the European Central Bank (ECB) cautious about winding down its bond purchases. We believe policy divergence supports the US dollar against the euro, and see US yields rising more than eurozone yields. We favour US inflation-protected securities over nominal bonds and over similar UK and eurozone instruments.

Conclusion: contrasting inflation outlooks suggest greater monetary policy divergence between the US and eurozone than markets are expecting.

Eurozone inflation in focus

Economic slack is the culprit in the eurozone’s sluggish inflation outlook. Our work finds that domestic activity, primarily spare capacity in the jobs market, is the main drag. Other key drivers of inflation are monetary policy and global factors such as commodity prices and the exchange rate. The ECB’s quantitative easing program has been only mildly effective in offsetting lingering domestic slack. See the Domestic drag chart.

domestic-drag-chart

The eurozone recovery should keep eroding this slack, but it still has a long way to go. Extra-loose policy is needed to ensure that inflation climbs back to target and stays there, we believe. Any sustained strength in the euro could weigh on inflation. Winding down monetary accommodation too quickly would risk inflation being stuck below target for even longer. See our September 2017 Getting to inflation’s core for details.

Conclusion: ongoing ECB policy accommodation is needed to help get inflation back near its 2% target.

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