Deflating data says take it easy

US and eurozone inflation data overnight confirmed what most market watchers and central bankers know and fear – we are witnessing a marked deceleration in inflation that threatens to spill over into deflation unless monetary policy settings remain at uber-easy levels for some time to come.

The US CPI fell by 0.4 per cent in April after falling 0.2 per cent in March for an annual rise of just 1.2 per cent. This is the smallest annual rise in the CPI since November 2010.

The core reading for inflation, which strips away price swings in food and energy, rose 0.1 per cent in the month and 1.7 per cent for the year. This low reading for core inflation extends the period in which it has been below 2 per cent, the informal target of the Federal Reserve, to over five years.

While the market was forecasting low CPI readings, based on the fall in petrol prices, both the headline and core inflation readings were lower than expected.

The market reaction was concentrated in bonds where the 10-year yield fell 7 basis points to 1.87 per cent, although at the end of trade, stock prices dipped to finish around 0.4 per cent lower. Not helping market sentiment was additional economic news in the US that showed a jump in unemployment claims, a sharp fall in housing starts and a dip in manufacturing conditions in Philadelphia.

In the eurozone, the final estimate of the CPI was unchanged from the preliminary estimate which was for annual inflation of just 1.2 per cent in April. Recall that when the preliminary estimate was published a few weeks ago, this was seen as the final straw that allowed the European Central Bank to cut official interest rates from 0.75 per cent to 0.5 per cent.

The news from the US and the eurozone should also be viewed in the context of news last week that inflation in China rose 2.4 per cent in the year to April, a result that was temporarily boosted by rising vegetable prices due to bad weather. In any event, inflation in China remains well below the 3.5 per cent target set by the government for 2013 as a whole.

With inflation so low and still generally decelerating, it is no surprise that global central banks are on edge. As witnessed in Japan over the bulk of the last 20 years, entrenched deflation can erode profits, wages, investment and spending and it is arguably as damaging to economic health as a bout of high inflation.

Low and generally falling inflation means that monetary policy settings should and no doubt will remain super easy. All of the major central banks are continuing to ease monetary policy with rate cuts, quantitative easing or a mix of both.

While some Fed officials in the US continue to publicly canvas the notion of ending quantitative easing, it will take a mix of stronger news for the economy and a pick-up in inflation before that occurs.

One of the high profile inflation and policy hawks in the US is Philadelphia Fed President Charles Plosser. Overnight he said that “things are better enough for the Fed to slow the pace of [bond] purchasing”. While Plosser is not a voting member of the Federal Open Markets Committee, his vocal stance cautioning against excessive quantitative easing has seen him attract followings within the markets.

It appears, for now, with the data suggesting a still problematic position in the US and with inflation particularly low, Plosser’s views are in the minority.

As has been noted before, the best way to judge global inflation pressures is to examine trends in commodity prices. The simple logic is that if commodity prices are moving higher, global economic activity is stirring. If prices are weak, there must be some shortcomings in the global growth position.

On that score, the broad commodity price indices remain flat to down. There is no sign of a sustained upturn in prices, particularly for industrial metals.

This says clearly that inflation will remain very low for some time to come and with that, monetary policy will remain easy, including, by the way, here in Australia. If there is an unexpected dip in global growth in the year ahead, it will be deflation and not inflation that will be worrying policy makers and markets.