Lower Inflation Poses Challenges For Central Banks

BoC Expected to Leave Rates Unchanged

US futures are pointing to a third session in the green for equity markets on Wednesday, extending the good run which has come on the back of a slightly less volatile geopolitical environment.

While nothing has necessarily improved, per say, the absence of retaliation since the air strikes by the US, UK and France in Syria last weekend has been welcomed by investors who are relieved at the current lack of escalation. With the Dow steadily creeping back towards 25,000, investors are becoming increasingly comfortable again although I feel it will not take much to shake things up again and send markets spiralling lower.

Dow (US30) Daily Chart

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Attention will once again be on first quarter earnings season today with another 10 S&P 500 companies reporting, including Morgan Stanley and American Express. We’ll also hear from the Bank of Canada which is expected to leave interest rates on hold, having only raised them to 1.25% in January. With inflation picking up though and unemployment at pre-financial crisis lows, it’s unlikely that they’ll remain unchanged for too long, even if growth has slowed over the last few quarters.

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UK Inflation Drop Poses a Challenge For BoE

The UK inflation data this morning may have thrown a spanner in the works for the Bank of England, which has for months been preparing markets for an interest rate hike, most likely in May. The central bank has long highlighted the above target inflation as a concern that requires a rate hike in order to bring it back towards target, despite the fact that it was primarily driven by a one-time currency depreciation, more than half of which has since been reversed.

UK Inflation

Just as it looked as though everything was falling into line for a rate hike – 43-year low in unemployment, record high employment, wages rising and inflation well above target – the data today has cast a shadow of doubt over it. If inflation is naturally trending back towards target, wage growth is only moderate and Brexit is causing uncertainty for the economic outlook of the UK, can the central bank afford to wait until later in the year before hiking?

While I think that would make sense, I wonder whether policy makers will feel somewhat compelled to raise in May having spent so long hinting at doing so and will compensate for this by stressing that another this year is unlikely. The inflation numbers today were well below expectations and represented another decline after peaking in November but that are still above target which may afford the MPC the ability to hike while still expressing concern about price pressures and the lack of slack in the labour market.

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Eurozone Inflation Data Unlikely to Prevent QE End This Year

Inflation in the eurozone also fell short of expectations this morning, causing another headache for the European Central Bank as it approaches the end of quantitative easing. The program currently expires in September and could end altogether then or be extended for another short period at a reduced rate as policy makers respond to an improved economic environment by removing the exceptional policy tools that have been used in recent years.

While the lower inflation numbers may not get in the way of them ending the QE program, it could cause delays in the start of rate hikes next year as it will act as evidence that there is still plenty of slack in the labour market.

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