Growth gathering momentum, but where’s the inflation?

LONDON (Reuters) – The euro-zone economy may be building up an impressive head of steam that shows no signs of cooling, but what policy makers at the European Central Bank really want – higher inflation – is still largely absent.

Industrial output in the bloc rose faster than anyone polled by Reuters expected in August, according to data last Thursday that followed a slew of forecast-beating releases and after the International Monetary Fund upgraded its outlook for global growth.

“Although the industrial sector only accounts for a quarter of GDP, it has been the euro zone’s most cyclical sector historically, and so is an important indicator of the economy’s wider health,” said Christian Jaccarini at CEBR. “With the economy gathering momentum, the European Central Bank should feel confident about starting to taper its asset-purchase program at the beginning of next year.”

The economy is performing stronger than at any time since the global financial crisis, so speculation the ECB will soon begin scaling back its massive stimulus program has been rife.

Policy makers at the ECB will announce on October 26 a six-month extension to its asset-purchase program but will cut how much it buys each month to €40 billion from January, a Reuters poll in September predicted.

Five people with direct knowledge of discussions told Reuters the ECB is homing in on extending its stimulus for nine months at the next meeting while scaling it back.

Yet the ECB’s key focus is inflation and numbers due on Tuesday will probably confirm prices only rose 1.5% in September on a year ago, still a lot weaker than the just-below 2% rate-setters would like.

According to Reuters polls taken throughout 2017, which have been correct about how low it would remain this year, inflation won’t hit that ECB target for years.

“There is likely to be only a limited pickup in inflationary pressures, meaning that interest-rate hikes can be kept on hold until 2019 – later than markets seem to expect,” economists at Capital Economics wrote.

BRITISH DILEMMA

Across the Atlantic, US Federal Reserve policy makers have already begun tightening but had a prolonged debate about the prospects of a pickup in inflation and slowing the path of future interest-rate rises if it did not, according to minutes of the central bank’s last policy meeting.

“Many participants expressed concern that the low inflation readings this year might reflect... the influence of developments that could prove more persistent, and it was noted that some patience in removing policy accommodation while assessing trends in inflation was warranted,” the Fed said in the minutes. Britain, however, has the opposite problem. Since the vote in June 2016 to leave the European Union, the pound has lost around 13% of its value against the dollar, driving up the costs of imports and causing inflation to run well above the 2% the Bank of England would like it at.

In the referendum’s aftermath, the BoE cut 25 basis points from borrowing costs, taking them to a recordlow 0.25%, hoping to stave off a predicted economic meltdown after the leave vote.

That meltdown never happened, and Britain’s economy was one of the best performers last year, although growth has since slowed sharply.

Still, at its November meeting, the BoE will raise interest rates for the first time in a decade, according to economists in a recent Reuters poll taken after a barrage of hawkish rhetoric from BoE policy makers. However, most of them also said raising rates now would be a policy mistake.

“On the strength of the MPC’s rhetoric and current market expectations, we continue to look for a November hike. But this assumes no significant downside surprises in the inflation and wage data [this] week,” said Allan Monks at J.P. Morgan. “If the MPC is minded to back out of tightening in November, in response to the data or the Brexit process, we would expect at least some hint of this in any commentary between now and the next meeting on November 2.”

Britain’s economy shows little sign of breaking out of its lethargy, and it is “extraordinary” the BoE is considering raising interest rates, the British Chambers of Commerce said on Friday.

“We’d caution against an earlier-than-required tightening in monetary policy, which could hit both business and consumer confidence and weaken overall UK growth,” BCC head of economics Suren Thiru said.

Divorce talks last week ended in deadlock over a British refusal to clarify how much it will pay on leaving, EU negotiator Michel Barnier said on Thursday.

But EU leaders could hand beleaguered British Prime Minister Theresa May an olive branch in Brexit negotiations this week by launching their own internal preparations for a transition to a new relationship with Britain, giving her some hope.