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Draghi’s Inflation Bets Firmer Than Fed: Cutting Research

European Central Bank President Mario Draghi may have more room for comfort if a working paper released this week is correct. Photographer: Andrew Harrer/Bloomberg
European Central Bank President Mario Draghi may have more room for comfort if a working paper released this week is correct. Photographer: Andrew Harrer/Bloomberg

May 2 (Bloomberg) -- Mario Draghi has more reason than Janet Yellen to be confident investors won’t question the ability of central banks to keep inflation on target.

Inflation expectations are key to the economic outlook in the U.S. and Europe because if investors doubt policy makers can keep consumer price growth near their goals, then price pressures may begin to fade toward deflation.

That may force Federal Reserve Chair Yellen or European Central Bank President Draghi to consider fresh monetary stimulus. Both cited the importance of managing expectations in the past month and face inflation below their stated preference levels.

Draghi may have more room for comfort if a working paper released this week is correct. It says European markets show a “somewhat stronger anchoring of inflation expectations in the euro area than in the United States.” That means investors are more confident the ECB will hit its inflation target of just below 2 percent in the medium term.

During the financial crisis which began in 2008, investor bets on inflation didn’t change in the euro area, while they slipped in the U.S., said economists Soren Lejsgaard Autrup and Magdalena Grothe, both of whom work at the ECB.

They reached that conclusion after studying differences in the yields of nominal and inflation-linked bonds and how they reacted to economic data from 2004 to 2012. So-called forward rates, which reflect where investors expect inflation to go, didn’t react to the release of inflation data in the euro area, whereas those of the U.S. did after the crisis. U.S. rates also moved on the publication of indicators such as employment.

“When medium- to longer-term inflation expectations are not influenced by economic news releases, it indicates that market participants are confident that monetary policy will be adjusted to counter any risk to the inflation objective of the central bank,” said Autrup and Grothe.

* * *

The bond market may soon start to ready itself for higher Fed interest rates if history is any guide.

A so-called flattening of the U.S. Treasury yield curve tends to start several months ahead of the first increase in the Fed’s benchmark rate, according to an April 29 analysis of historical data by Barclays strategist Guillermo Felices. He expects the Fed to raise rates in the second quarter of next year.

A flattening -- when short-term bond yields rise relative to longer-term ones -- was the case when the yield curve was steep in 1992 to 1993 and 2003 to 2004 as rate increases neared, according to Felices.

Stocks and the U.S. dollar showed more of a mixed response than bonds, he said. The dollar, for example, appreciated in two of the past four tightening periods, weakened in 1994 and was stable in 2004.

* * *

The U.K.’s cost of borrowing is set to rise as opinion polls show an increase in support for Scottish independence.

Surveys ahead of the September referendum on whether Scotland should break with the rest of the U.K. show the gap between proponents and opponents is closing. That may mean higher U.K. gilt yields, according to Costas Milas of the University of Liverpool and Tim Worrall of the University of Edinburgh.

Of 54 surveys conducted since the start of 2012, support for independence has trailed by an average of 15.5 percentage points. Nevertheless, the gap narrowed to 12 points in March from 24 points in November.

Milas and Worrall estimate that a 12-point swing in support for independence raises 10-year borrowing costs for the U.K. as much as 24 basis points relative to 5-year rates. Among reasons to expect longer-term yields to rise more than shorter-dated ones is that there would probably be lengthy negotiations with an uncertain outcome.

Any increase in bond yields would complicate the U.K.’s debt management, given that a fifth of bonds due to be auctioned this year and next have maturities between seven and 15 years.

With the government selling about 26.9 billion pounds in long-term gilts, the cost of independence may be about 130 million pounds per year on debt financing alone if the government has to pay higher interest rates on its borrowing, the economists said.

* * *

A hard landing in China’s economy would be enough to knock an average 0.4 percentage point off global growth over the next three years.

That’s the scenario painted by IHS Inc., an Englewood, Colorado-based consulting firm. Its economists assume a crash of the Chinese housing market would prompt a tightening of credit conditions as well as cutbacks in investment and consumption.

That would set off a period of falling prices and reduce growth to as low as 4.8 percent next year, said IHS, which sees the risk of such an outcome as one in three. By the end of 2016, the level of global output would be 1.2 percent lower than if China had dodged a hard landing.

Japan’s gross domestic product would be 1.1 percent lower by 2018, while Australia’s would be 2.2 percent less, according to the April 29 report. Lower revenue from oil exports would hurt the Middle East and oil prices could fall as low as $50 a barrel if China weakened even more.

* * *

It may be too soon to declare the U.S. economy will be weaker in the future than in the past.

Joseph G. Carson, director of global economic research at AllianceBernstein LP., is challenging economists such as Robert Gordon of Northwestern University and Harvard University’s Lawrence Summers, who say the U.S.’s potential growth rate -- the rate that triggers inflation -- is on the wane for reasons ranging from a lack of fresh technological breakthroughs to weak demand.

Carson says if you strip out the government contribution to the economy, the private sector has grown an average 3.5 percent over the past four years, matching the pace of the non-state expansion following the 2001 recession.

“The preliminary evidence supports the thesis that potential growth has slowed, but it may not do so as conclusively as some of the pessimists suggest,” said Carson, a former economist at General Motors Co., in an April 25 report.

He noted in 1997, the Congressional Budget Office projected potential growth of 2.1 percent for the next decade. Four years later it estimated the rate at 3.3 percent.

Expansion in shale gas and oil production could now spark a growth resurgence as could a rebound in investment in consumer-goods industries, Carson said.

* * *

The Bank of England’s bond-buying program has boosted the wealth of the U.K.’S richest 5 percent by an average of 215,000 pounds per household, according to a study released this week.

So-called quantitative easing “has created a significant redistribution to the rich -- effectively a Robin Hood tax in reverse,” said Rob Thomas, a former BOE economist and now director of research at the Wriglesworth Consultancy in London.

By increasing the prices of shares and bonds, the bank’s policy has increased inequality by favoring those with assets, 40 percent of which are held by the top 5 percent, said Thomas.

The group’s total windfall has been 280 billion pounds. Among the losers are those with pensions, with Thomas estimating someone with a 100,000 pound pension pool could be 1,900 pounds a year worse off.

* * *

About half of 35 countries examined by investment bank Renaissance Capital are “highly unlikely” to witness regime change, based on their 2009 per capital gross domestic product.

Argentina, Bulgaria, Croatia, Estonia and Lebanon are now “immortal democracies,” after their annual economic output per capita each exceeded $10,000, according to the study entitled “The final frontier and beyond.”

Ukraine and Tunisia, the former threatened by Russian intervention and the latter recovering from political unrest, are “years away” from securing that status. Each, though, have only a 1 percent chance a year of losing democracy, according to the report.

The study also finds that countries with less than 25 percent to 30 percent of children in secondary schools will be poor 20 years later. Based on 2011 education levels, only 14 countries are in that category, 13 of which are in Africa.

To contact the reporters on this story: Simon Kennedy in Paris at; Alaa Shahine in Dubai at

To contact the editors responsible for this story: Craig Stirling at Anne Swardson, Paul Badertscher

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