Tuesday, 21 November 2006

Is higher inflation a greater concern than slower growth?

The ECB continues to warn about inflation. Bloomberg reports:

European Central Bank President Jean-Claude Trichet said he and his Group of 10 colleagues must be "strongly vigilant" about the risk of inflation because of dynamic global growth.

However, the German Federal Statistical Office reported yesterday that the index of producer prices for industrial products was up 4.6 percent in October 2006 from the corresponding month of the preceding year, down from 5.1 percent and 5.9 percent in September and August respectively.

The data from the UK yesterday was perhaps more supportive of Trichet's view. M4 money supply growth eased in October to 0.9 percent, but the annual growth rate was 14.0 percent, just slightly down from the 16-year high of 14.5 percent in September. In the meantime, the latest reading of the Rightmove house price index showed that average asking prices for houses in England and Wales rose 12.4 percent year-on-year between October and November, the fastest pace in 2 years, taking prices to a record high. The UK housing market has clearly been supported by strong lending, as net mortgage lending rose by 5.5 billion pounds in October according to the British Bankers' Association yesterday, up from a 5.4 billion pounds increase in September and just below the monthly average of 5.6 billion over the last six months.

Meanwhile in the US, slow growth looks likely to continue, based on the Conference Board's leading index for the US economy.

The Conference Board announced today that the U.S. leading index increased 0.2 percent, the coincident index increased 0.1 percent and the lagging index increased 0.2 percent in October...

The leading index now stands at 138.3 (1996=100). Based on revised data, this index increased 0.4 percent in September and decreased 0.3 percent in August. During the six-month span through October, the leading index decreased 0.2 percent, with five out of ten components advancing (diffusion index, six-month span equals fifty-five percent).

Nevertheless, the increase in the leading index in October at least gives some credence to Morgan Stanley's Richard Berner's view that US growth and inflation might yet pick up.

As I see it, the case for lower inflation — over time — is solid, and we still think that inflation will peak over the next several months. But the judgment that the peak has already passed is likely premature for three reasons. First, inflation expectations are still slightly elevated despite the slide in energy quotes over the past three months. Second, while growth has slipped below trend, measures of slack in both product and labor markets continue to suggest that companies have pricing power and that costs are likely to rise. And we continue to expect a pickup in growth, which would refresh pricing power and push costs higher. Finally, and perhaps most controversially, the global dimension matters: Global growth relative to capacity is still strong, boosting US import prices despite relative stability in the dollar. As a result, I believe that the current inflation lull won’t last and that inflation risks are still tilted higher.

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