Economy in Brief

With the Bank of England set to meet, markets are vetting the CPI report for the United Kingdom from the standpoint of what it will cause or permit the Bank of England to do next. The year-over-year inflation rate in this report has dropped causing some analysts to say it keeps the door open for a Bank of England rate cut.

But does it really?

I am not a fan of looking at short-term inflation indicators or for central banks to make policy based on what short-term inflation indicators are doing. However, central banks need to be aware of what these indicators are doing and what they're telling them about inflation. As I have mentioned many, many times, year-over-year inflation rates are well behaved, but we must be careful in vetting them. The best way to think of them is that they are the result of 12-month-to-month inflation changes over the past year. Each month the inflation rate has eleven of those same changes as the previous month. If 12-month inflation falls in the current month compared to the previous month, it means that the month-to-month inflation change in the current month is lower than the month-to-month inflation change and the oldest month that was just dropped out of the index. Is that a reason for a central bank to cut interest rates today?

The only answer to this question that stands up to scrutiny is this: it depends. And what it depends upon is the context and the trend. It depends on how broad the change in inflation is. It depends on whether that change in inflation is driven mostly by one category like changing energy prices. It depends on how economic performance has shifted recently (if at all). ‘It depends’ means there must be context for it.

In this case, the CPI-H month-to-month just rose by 0.5% in February, not exactly a very good number- a number that's going to annualize to an inflation rate of over 6%. That's not particularly good. On the other hand, the inflation rate year-over-year goes down because a year ago the CPI-H is dropping out a rise in the price index month-to-month of 0.9%. Clearly 0.5% is less than 0.9%! Viola! The year-over-year inflation rate falls. However, viewed on its own that 0.5% inflation rate is quite high. Also, the CPI-H core index that excludes food, alcohol, tobacco, and energy, rose by 0.4% in February; that's also a pretty strong increase. The headline month-to-month annualizes to 6.2% while the core annualizes to 4.9%. Neither of these strike me as performance that is good enough to accommodate a rate reduction by a central bank with a 2% target and a long legacy of overshooting its target. In fact, if we compare those annualized increases to the CPI-H over 12 months, the 12-month index increased 3.9%, the six-month increase was at an annualized rate of 3.3%, and the three-month increase in the CPI-H was at a pace of 4.9%. The one-month annualized change represents an acceleration compared to all these metrics (Yikes!). Similarly, the core for the CPI-H rises 4.8% over 12 months, rises at an annual rate of 3.7% over six months and at a 4.2% pace over three months. However, the annualized one-month increase is 4.9%, once gain stronger than all those metrics.

I'm not advocating that the central bank look at the annualized month-to-month number to make policy. However, the central bank should not ignore it either… The central bank needs to look at a sequence of these numbers and have some idea about how inflation is ‘trending’ if it's going to change policy. And since the Bank of England - like the Federal Reserve and the European Central Bank - has been over the top of its target for some time, it would seem most appropriate for the central bank to make sure that inflation rate is on the correct downward path and at a more acceptable pace before it begins cutting interest rates.

As this discussion made clear, almost all the focus on today's CPI report is based upon how it's going to fit into BOE policy and how the year-over-year rate dropping paves the way for the Bank of England to become more accommodative. However, in my view, that's not even close to right.

There is good news however... The good news is that the sequential inflation calculations for the headline and the core are not clearly accelerating and they're showing some temperance. The diffusion results from these calculations show that inflation over 12 months compared to the previous 12 months, over six months compared to 12-months, and over three months compared to six-months is demonstrating a step down across most categories persistently. That is very good news. The diffusion indexes are less than 50 (less than 50%) indicating that inflation is declining in more categories than it's increasing, period-to-period. And that's reassuring. However, diffusion calculations are executed across categories and summed-up without weighting. The actual inflation index employs weighted components, and the weighting is clearly an important part of the process. However, if we find that inflation is not broadly accelerating, that may be a sign that the inflation process is moderating and that it is also poised to put in some lower numbers in those categories that have higher weights that are presently still performing poorly.

Monthly diffusion...not so fast The monthly numbers are not as attractive as the sequential calculations for diffusion. In February, the diffusion calculation is at 54.5%; that’s up sharply from a 36.4% reading in January; January is down sharply from a 72.7% figure in December. The monthly numbers compare the month-to-month percent changes in inflation to those of the month before. Diffusion above 50 tells us that inflation is accelerating in more categories than it's decelerating. February and December show broad-based inflation acceleration while January brought respite with more deceleration than acceleration.

Diffusion calculations are important. They tell us about the breadth (not the intensity) of inflation. No central bank really makes policy based on the breadth of inflation, but it's still an important statistic to keep track of.

The tectonic plates did not shift under the feet of the ZEW forecasters in March. However, there was a small improvement in the economic situation and in macroeconomic expectations for both the United States and for Germany in the March ZEW survey.

The Eco-situation: The economic situation finds an improvement in Germany to -80.5 in March from -81.7 in February. This is still a highly negative reading and only a small improvement in the U.S. The economic situation reading in the U.S. rose to 37.9 from 34.0; for the euro area the current situation assessment worsened slightly to -54.8 from -53.4. Ranking these economic situation data back to the early 1990s shows the euro area ranking is in the slower 29th percentile, the German ranking is in its lower 11th percentile, and the U.S. ranking is above its median for the period; i.e., it is above a standing at 50, with a 55.3 percentile standing in March.

Macro-expectations: Macroeconomic expectations are assessed for Germany and the U.S., both show improvements in March although the German assessment at 31.7 improves much more than the U.S. assessment as the German assessment moves up from 19.9 in February. The U.S. assessment improves to -5.7 in March from -6.1 in February, a tiny move by comparison. The ranking for German expectations is above its historic median at a 58.6 percentile reading while the U.S. reading is only at a 41.1 percentile reading, moderately below its historic median. Obviously, current U.S. circumstances are much better than circumstances in Germany; however, the ZEW experts see more improvement in Germany ahead than in the U.S.

Inflation expectations: Inflation expectations tilted to continued low or declining inflation in the euro area and in Germany while in the U.S. the tilt moved slightly away from expectations of inflation declining as much. However, these month-to-month changes are minor and the queue standings for the outright assessments rather than the change for inflation put the euro area, Germany, and the U.S. all in the lower 10 percentile of their historic ranges- highly similar rankings.

Interest rate habitat: So, with inflation remaining low with little change in prospect, with the current economic situation weak - showing only marginal changes, and with macroeconomic expectations showing essentially moderate readings for the U.S. and Germany, although stronger readings for Germany, the ZEW experts continue to see interest rates remaining low.

Short-term rates: The month-to-month change for short-term interest rate expectations in the euro area fell to -80.3 in March from -65.0 in February, a considerable downshift. In the U.S., the reading fell to -78.3 from -71.1, still expecting a downshift in rates. The standing of these expectations puts both the U.S. and the euro area short-term rate expectations in the lower 5th percentile of their historic range.

Long-term rates: Long-term rate expectations are assessed for Germany and the U.S.; both show stepped up negative readings in March compared to February. The U.S. now has the lowest queue standing in this evaluation period. While the German standing has been lower only about 2.2% of the time. Declines in long-term interest rates are widely expected in both Germany and the U.S. and this is despite an above median standing for U.S. economic situation and a significantly improved macroeconomic expectation for Germany. This month, it's not exactly clear to me how the economic situation, macro-expectations, inflation expectations, and interest rate expectations fit together. There seems to be a little bit more dissonance among these readings than there has been in the past.

Part of this probably comes from my observation of current inflation numbers that show the actual declines in inflation slowing down. Growth is still relatively strong-to-solid in the United States. These observations make it hard for me to understand both the interest rate and the inflation expectations that the ZEW experts put forth for the United States.

Tectonic shifting- One place where the tectonic plates did shift is for stock market expectations. The euro area stock market expectation fell from 21.3 in February to 1.9 in March. In Germany, the expectation fell from 17.5 to -4.0. In the U.S., it fell from 18.8 to 7.3. These expectations leave Germany and the euro area with queue standings in their lower 2 1/2 percentile, while the U.S. has a standing at its lower 18th percentile. I would find it easier to deal with degraded expectations for inflation and interest rates than to see them appear for equities as they have in this survey but here, they are. We do have evidence that the ZEW experts are beginning to change their tune and their outlook for Europe and the United States. For now, these changes and their expectations still need to be fine-tuned as the experts need to digest changing economic circumstances, perhaps a new path for inflation, a change to the outlook for central bank behavior, and potentially a different look for growth for the period ahead.

The January trade balance in the euro area surged sharply into a stronger surplus at €28.0 billion, up from €14.3 billion in December, doubling in one months’ time. The 12-month average for the trade balance is a surplus of €8.3 billion. The average over the previous three months is €19.3 billion.

A larger surplus; a smaller deficit The improvement comes about in January through two sources: one is the balance on manufacturing trade where the surplus rose to €47.75 billion from €37.8 billion in December. The average surplus over the last 12 months is €34.2 billion. The second source of improvement is the balance on nonmanufactured goods, a trade balance that is in deficit. That deficit got smaller in January at -€19.7 billion as it improved from -€23.5 billion in December. Over 12 months the average deficit on nonmanufacturing trade is -€25.9 billion. Month-to-month there's improvement on both the manufacturing and the nonmanufacturing balance of the €14 billion improvement, about €10 billion of it comes on the manufacturing side with the rest on the nonmanufacturing side. That occurs with the manufacturing surplus getting larger and the balance on nonmanufacturing goods showing a smaller deficit.

The story of trade improvement is told by clearly different trends for exports and for imports. If we divide exports and imports into manufactured and nonmanufactured goods (as we did in the description above), we do see some quite different growth rates; however, in both cases the trends work to produce an improved trade balance for the euro area.

Trade in Manufactures Manufactured goods show exports fluctuating around a slight increase or little-change, falling by 1.2% over 12 months, rising slightly over six months, then falling at a 2.1% annual rate over three- months. Compare this to manufacturing imports where imports fall 13.8% over 12 months, fall at a 20.1% annual rate over six months, and then fall at a 27% annual rate over three months. While exports are floundering and holding around the zero-growth mark, imports are clearly plunging on all horizons with the import growth rates getting weaker over more recent periods. These trends obviously lead to an improved trade performance as the trade balance moves into larger surplus on more or less unchanged manufacturing exports amid plunging manufacturing imports.

Trade in Nonmanufactures Turning to nonmanufacturing trade on the export side, we see exports growing and accelerating over the different horizons, from 4.4% over 12 months, to a gain at a 33% annual rate over six months, to an increase at a 53% annual rate over three months. Nonmanufacturing imports, on the other hand, show persistent declines, however, amid withering weakness. Nonmanufacturing imports fall by 23.9% over 12 months; that's reduced to a decline of only 0.3% at an annual rate over six months, although it rebounds to a decline of 12.2% annualized over three months. Nonmanufacturing imports are declining on all horizons as the tendency for decline diminishes over more recent periods; however, this effect is being swamped by exports where the exports of nonmanufacturing goods are growing and are growing more strongly over shorter periods.

The two largest EMU Nations Looking at the two largest economies in the European Monetary Union, we see German exports growing over 12 months, six months, and three months and growing stronger over those horizons. The same trend is true of French exports which grow on all horizons and grow stronger as well. German imports contract over all horizons and French imports contract over all horizons. We see reinforcing trends in both Germany and in France behind the overall Monetary Union trends.

The U.K. The U.K., a European economy that's not a member of the monetary union or the European Community, shows exports and imports both declining over 12 months and over six months, with both trade flows improving over three months and with exports being slightly stronger over three months.

Other EMU Exports Export trends for Finland, Portugal, and Belgium - all of them monetary union members - show different patterns. For Belgium, exports decline on all horizons and are weaker over three months than over 12 months. For Portugal, exports decline over 12 months but gain pace and rise over six months and over three months. In Finland, there are double-digit declines in exports over 12 months and six months, and roughly unchanged performance over three months.

In this week's newsletter, we examine the key takeaways from the National People's Congress (NPC) in China. Initially, we highlight the government's economic objectives for the year ahead, including for a real GDP growth of "around" 5% and an inflation rate of "around" 3%. Following this, we examine potential obstacles that could impede China's achievement of these targets, including persisting drags from China’s property sector and still-subdued domestic inflation. We move next to take stock of China’s latest hard data, which revealed consensus-beating growth in the manufacturing and retail sectors. We note, however, that any interim stabilization is likely still in nascent stages. Subsequently, we analyze China's ambitions for its labour market, taking into account underlying trends of rural migration and broader demographic challenges. Finally, we investigate China's budgetary strategies for the year, focusing on the government's deficit targets with a nod to its plans for increased special bond issuance. While many would agree that China could do more with fiscal policy given persisting domestic woes, the extent of government debt growth will likely draw continued concerns.

Growth The Chinese government has set a GDP growth target of “around 5%” for 2024, unchanged from its goal for last year. The Chinese economy managed to log real GDP growth of 5.2% in 2023, having just barely exceeded its modest target while grappling with a slew of challenges (chart 1). Namely, China has faced, and continues to face headwinds from a struggling property sector, elevated local government debt levels, and fragile consumer confidence, among others. Also, recent official PMI data reveal a widening divergence between China’s manufacturing and non-manufacturing sectors. Specifically, the PMIs indicate ongoing, albeit mild, contractions in China’s manufacturing sector while the non-manufacturing sector has seen an accelerated pace of expansion.