Could the Eurozone be more inflationary than the US? - Westpac

Richard Franulovich, Research Analyst at Westpac, explains that the US recovery is substantially more advanced than the Eurozone and the regions’ relative inflation rates confirm as much.

Key Quotes

“US core PCE has averaged 1.7% in the last year, not far from the Fed’s target, while EZ core inflation has averaged a feeble 0.9%. Reflecting that the Fed is much farther down the path of normalisation while the ECB has barely begun a serious conversation about policy normalisation.”

“However, a closer look at the link between the EZ labour market and inflation raises the highly controversial possibility that the EZ could soon start to look more inflationary relative to the US. Both the 2yr and 10yr Bund-Tsy spreads are hovering around -200bp. An EZ that suddenly seems more “inflationary” relative to the US could trigger significant recovery in those spreads with meaningful upside risks to the EUR/USD exchange rate.”

“On current trends EZ core inflation is set to pick up faster than in the US.”

“In the last 2 years EZ unemployment has fallen at a -0.07ppt average monthly pace. Extrapolating that puts EZ unemployment at 8.7% in a year’s time, from 9.5% currently. Our simple regressions suggest an 8.7% unemployment rate would see EZ core inflation at 1.65% in a year’s time, a marked acceleration from the 0.9% average annual rate over the last 3mths.”

“US unemployment has fallen a slower -0.04ppts p/month over the last 2yrs. At that pace US unemployment hits 4.1% in a year’s time. Applying the US regression equation to a 4.1% unemployment rate puts core PCE at 1.85% in a year’s time, up moderately from an average 1.7% pace in the last 3mths.”

“The US recovery may be more mature but with: 1) EZ unemployment falling more quickly than it is in the US; and 2) with EZ core inflation apparently more responsive to the region’s labour market than in the US, the EZ could potentially experience a faster acceleration in inflation in the year ahead than the US.”

“If EZ labour market and inflation underperformance relative to the US continues to diminish the Bund-Tsy spread could see a significant recovery with bullish implications for the EUR/USD exchange rate.”