Inflation Dropping in the U.K., U.S. and Euroland

November 18, 2008

Falling food and energy costs have spearheaded a reversal of inflation that is being felt pretty universally. Key price indices were released today by Britain and the United States. British consumer price inflation for October fell to 4.5% from 5.2% in September, which was also the third-quarter and cyclical high. The 0.7 percentage point reduction was the biggest in 14 months. Food price inflation decelerated to 10.1% from a peak of 13.0%, and energy cost inflation dropped to 24.2% from 29.7%. The United States later today announced the largest monthly decline of producer prices in the 61-year history of that data series and a decrease in the on-year advance to 5.2% from a top in the third quarter of 9.8%. Energy prices rose just 5.5% in the year to October compared to 28.0% in the year to July. Food costs decelerated at the wholesale level to a 12-month advance of 6.5% from a peak of 9.1% in August. At the end of last week, consumer prices in the euro area were reported to have risen 3.2% in the year to October, down from a peak in 3Q of 4.0%. Energy inflation had almost halved to 9.6% from a high of 17.1%, and food inflation had dropped two percentage points from peak to 4.7%.

But for the trend in core inflation, there was a notable difference in Euroland and Britain on the one hand and the United States on the other. U.S. core PPI is still cresting, posting back-to-back monthly gains of 0.4% and climbing to a 12-month increase of 4.4% from 4.0% in October and 3.0% at midyear. Core CPI had edged down to 2.4% from a peak in 3Q of 2.6% in Euroland and to 1.9% from 2.2% in Britain. It is ironic that the Fed pays most attention to core inflation, while the Bank of England and European Central Bank target total inflation. Maybe the difference reflects this comparison of a U.S. wholesale price trend’s change to the recent behavior of European consumer prices. Or maybe it reflects the earlier aggressive policy shift by the Federal Reserve, which has the U.S. benchmark rate still 225 basis points below its ECB counterpart and 200 basis points less than the British key rate. Or just maybe, the discrepancy is due to slower growth in Europe than in the United States in the last two calendar quarters.

Long-term interest rates have declined in all three economies, but the U.S. declines have not been as steep. The table below documents monthly averages for 10-year Treasury, bund, and Gilt yields. Compared to July averages, the Treasury-bund yield differential has contracted by 43 basis points, and the Treasury-Gilt spread decreased by 40 basis points. Since mid-July, the Fed and ECB eased by 100 basis points apiece, while the Bank of England’s repo rate was slashed by 200 basis points. It doesn’t seem likely that the larger decline in European long-term rates was caused by a bigger drop-off in expected inflation or by the prospect of greater future central bank rate cuts in Europe than in the United States.  I’m more sympathetic to the possibility that qualms about an explosion of U.S. deficit spending could be retarding the move to lower U.S. rates as the recession deepens. In light of the firmer dollar tone, it would actually have been sensible to have seen U.S. rates post the steeper decline. Clearly, this is a situation to watch.

10Y Yields, % U.S. Germany Britain
July 3.98 4.52 4.92
August 3.89 4.21 4.63
September 3.69 4.11 4.50
October 3.79 3.90 4.48
Nov thru 11/17 3.75 3.72 4.25
Latest 3.54 3.65 4.08

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