The ECB held a meeting yesterday and, although the forecasts for the GDP were indeed lowered, the market turned a deaf ear to the bearish part of the report as it was information that was rather anticipated. The market focused instead on Draghi’s verbal assessment of economic recovery and comments on inflation.
After the July and August CPI miss, the case for core inflation was not very good: in July the indicator fell to 1.1% and then to 1.0% in August which failed to meet projections. There was an uncertainty about how the ECB will react to these changes.
However, commenting on inflation, Draghi initially maintained neutrality, saying that “measures of underlying have generally remained muted”. But moderate optimism crept into the market after the words “the price pressure on the domestic market is increasing and strengthening,” “the uncertainty about future inflation is receding.” According to the head of the ECB, “by the end of the year favorable conditions for inflation will continue to develop, and in the medium term, it will continue to grow”.
More importantly, Draghi put an end to the pessimism about the data in July and August, saying that the ECB expects “a significant improvement in core inflation.”
Regarding the asset-purchase program there is nothing new or important, ECB anticipates a decrease to 15 billion euros in October and stopping the program by the end of 2018.
The emphasis on the Italian crisis squeezed bears shorting the euro on political instability in Europe. Draghi lifted the mood reminding that the Italian authorities have agreed to adhere to the budget rules of the EU and there is no imminent threat of crisis contagion.
Meanwhile the dollar which had lost all sensitivity to positive surprises on the economic front, was faced with the first serious reminder of the limits of the expansion of the American economy. Consumer inflation in the US slowed in August, following a slowdown in industrial inflation. The source of moderate data was a 1.6% drop in textile prices, deflation (-0.3%) was also observed in major commodity items and prices for medical services also failed to increase (-0.2%).
Interestingly, the demand for new cars was moderate, as prices in August did not change compared to July, while inflation of used car prices suggests that consumers prefer cheaper durable goods.
The main part of inflation is formed by services, while inflation for basic goods keeps around zero:
Under the conditions of tariffs, which are a powerful source of inflationary pressure, a slowdown in inflation may indicate a depletion of the potential of consumer demand. In other words, the burden of tariffs imposed on the consumer can turn out to be unbearable at one time, and now when there are signs that the main support of the American economy starts to bend, US authorities will have to be much more cautious both in terms of foreign policy (trade wars) and with respect to monetary measures.
Of course, this warning can be countered by the fact that payroll data for August (an increase of 0.4% with a forecast of 0.2%) denies imminent danger, but if we consider that firms react to changes in aggregate demand after the changes occurred (and already adjusted salaries), then it can be assumed that wage growth will slightly lag behind the development of inflation.
The Fed probably received signals about a possible slowing of inflation in August, which is why when Powell was in Jackson Hole, he discussed his intention not to rush with the rate hike and to allow some overheating in the economy. At the end of September, the Fed will hold a meeting and the rate hike is warranted at the meeting, but rumors about the impact of a new portion of inflation data on Fed forecasts paves the way for the development of a negative scenario for the dollar.
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