Oiling The Wheels Of Inflation

Last week was a quiet one for markets, with both equities and bonds down slightly. Global equities are currently off some 2.5% in local currency terms from their July high and a rather smaller 0.8% in sterling terms, due to the pound’s retreat against a stronger dollar to $1.25.

Oil is once again back in the headlines and poised to complicate the recent story of a marked fall in headline inflation. Saudi Arabia and Russia have announced an extension of their 1.3mn b/d production cuts to the end of the year and the Brent oil price has hit $90 a barrel for the first time since last November. Crude prices are up 25% from their lows in early summer and, along with higher refining costs, are putting petrol prices under upward pressure again.

Whereas energy prices have recently been a major factor driving headline inflation down, as last year’s sharp rises have dropped out, they now look set to push it up somewhat. This Wednesday could see US inflation move back up to 3.6% in August from a June low of 3.2% and the following Wednesday UK inflation rise from 6.8% to a bit above 7%.

Core inflation, which excludes both food and energy prices, remains the main focus of central banks. Even so, the rise in headline inflation will make uncomfortable headlines and can only at the margin reinforce the upward pressure on wages.

The impact on growth of higher oil prices will be less noticeable but should still represent a small drag – more so for Europe and to a lesser extent the UK, than the US which is a net oil and gas exporter. This echoes other news of late which has pointed to a weakening in the European and UK economies but continued resilience in the US.

Business confidence in the service sector, which has weakened considerably in the Eurozone and UK, has held up much better in the US. And crucially, there is still no sign of a major downturn in the US labour market. By contrast, much of the Eurozone growth reported for the second quarter was revised away last week.

Here in the UK, the Halifax announced a larger than expected 1.9% drop in house prices in August, a reminder that much of the effect of the monetary tightening is still feeding through. Both the Halifax and Nationwide indices now show house prices down around 5% from their peak last summer.

The coming two weeks see the Fed, ECB and BOE all meet and market attention will once again, not that it has ever really moved away, be focused on when rates will peak and at what level.

First off, is the ECB this Thursday. Here the decision looks finally balanced as to whether or not they raise rates a final 0.25% to 4.0%; core inflation of 5.3% argues for a hike while the recent weakening in the economy argues against.

At next Wednesday’s Fed meeting, the market is firmly of the opinion that rates will be left unchanged at 5.25-5.5%. This comes on the back of a host of comments from officials all pointing in this direction. While most likely rates have now peaked, the Fed remains in data dependent mode and a final rate hike later this year cannot be ruled out.

As for the BOE meeting next Thursday, Governor Andrew Bailey last week downplayed the necessity for further hikes, saying rates were much nearer their peak than before. Still, barring a pleasant surprise in either the forthcoming wage or inflation numbers, a 0.25% rise to 5.5% looks on the cards. But if so – famous last words – this is likely to be the last.

Rupert Thompson – Chief Economist