A post in November presented a “monetarist” forecast that CPI inflation would rise to more than 3% by late 2021. This forecast appears on track.

The Bank of England’s central projection for Q4 2021 was 2.1% in November. This was lowered to 1.9% in February but raised to 2.5% in May.

A key element of the November forecast was a significant inflation boost from energy prices, reflecting a view that a strong global industrial recovery would push up oil and other commodity prices. This has played out: the CPI energy component rose by 7.5% in the year to April, contributing 0.5 percentage points (pp) to annual CPI inflation of 1.5%.

The energy effect explains the upward revision to the Bank of England’s forecast. The Bank now expects the contribution of energy prices to annual inflation to rise further to 0.75 pp by Q4 – similar to the view here, which assumes an additional 5% increase in the Ofgem price cap in October.

The forecast that CPI inflation will exceed 3% by year-end is driven by three additional factors:

• The planned increase in VAT in the hospitality and tourism sectors from 5% to 12.5% in October, with a return to 20% scheduled for April 2022.
• A pick-up in food price inflation, partly reflecting recent strength in global food commodity prices.
• A rise in underlying core inflation (i.e. excluding the VAT effect as well as energy / food contributions) in lagged response to faster broad money growth.

Taking these in turn, the forecast assumes that there will be 35% pass-through of the VAT rise to prices, implying a 0.2 pp boost to the monthly change in the CPI in October. The Bank and consensus, by contrast, appear to assume a negligible impact. This is surprising: firms face rising costs and the withdrawal of government support while economic reopening should ensure strong demand – why would they allow margins to take the full hit from the VAT hike?

Food prices have so far been weaker than assumed in the November forecast here, falling by 0.5% in the year to April. Producer output prices of food products, however, were up by 2.3% over the same period, the largest annual rise since 2018 – see chart 1.

Chart 1

The pick-up in producer output prices appears to have been driven by higher input costs of home-produced food. Imported food materials, by contrast, have cheapened, partly reflecting sterling appreciation. This is about to change: the FAO global food commodity price index rose by 17% in sterling terms in the year to April – chart 2.

Chart 2

The forecast here continues to assume that annual CPI food inflation will rise to 2.0% by December.

The final element of the forecast is an expected further rise in underlying core CPI inflation. Actual core inflation (i.e. excluding energy, food, alcohol and tobacco) was 1.3% in April but the assumption of 35% pass-through of the VAT cut in hospitality and tourism implies a significantly higher underlying rate, of 1.9%. The underlying rate has risen from a low of 1.2% in May 2020.

Research previously reported here found a consistent directional leading relationship between broad money growth and underlying core inflation, albeit with a variable lead time influenced particularly by exchange rate movements – chart 3. The surge in annual broad money growth, as measured by non-financial M4, from 3.6% at end-2019 to a likely peak of 16.1% in February suggests further upward pressure on the underlying core rate in 2021 -22 – the assumption here is that it will rise to 2.1% by December.

Chart 3

Chart 4 shows forecasts for headline, core and underlying core CPI Inflation through end-2021 based on the above assumptions. The headline rate finishes the year at 3.1% – slightly lower than in the November forecast because of the Budget decision to postpone full reversal of the VAT cut until 2022.

Chart 4

The forecast here remains that global industrial momentum, as measured by the manufacturing PMI new orders index, is at or close to a peak, with a multi-month decline in prospect.

The basis for the forecast is a fall in global six-month real narrow money growth from a peak in July 2020 – the rise into that peak is judged to correspond to the increase in PMI new orders to an 11-year high in April.

Available April monetary data indicate that real narrow money growth fell further last month, suggesting that the expected PMI decline will extend into late 2021 – see chart 1.

Chart 1

The presumption here is that PMI weakness will be modest, partly reflecting a view that the global stockbuilding cycle will remain in an upswing through H2. The cycle has averaged 3.5 years historically and bottomed in Q2 2020, suggesting a peak in Q1 2022 assuming an upswing of half-cycle length. Large declines in PMI new orders (i.e. to 50 or below) have usually occurred during cycle downswings.

Any PMI pull-back, however, could have significant market implications given consensus bullishness about global economic prospects.

Historically, a declining trend in global manufacturing PMI new orders has been associated with underperformance of cyclical equity market sectors and outperformance of quality stocks within sectors. The price relative of MSCI World cyclical sectors to defensive sectors peaked in mid-April, falling to a three-month low last week – chart 2.

Chart 2

The decline has been driven by a correction in tech – the MSCI cyclical sectors basket includes IT and communication services. The price relative of non-tech cyclical sectors to defensive sectors has moved sideways since March.

The MSCI World sector-neutral quality index, meanwhile, has recovered relative to the non-quality portion of MSCI World since March, following underperformance in late 2020 / early 2021 when cyclical sectors were rising strongly.

Equity market behaviour, therefore, appears to have started to discount a PMI roll-over, although confirmation is required – in particular, a breakdown in the price relative of MSCI World non-tech cyclical sectors to defensive sectors.

A sign that this could be imminent is a recent sharp fall in the non-tech cyclical to defensive sectors relative in emerging markets – chart 3. A possible interpretation is that the decline reflects worsening Chinese economic prospects, with China likely to be a key driver of a global slowdown. Early Chinese monetary policy easing may be required to mitigate this drag and lay the foundation for a resumption of cyclical outperformance.

Chart 3

Chinese money trends continue to give a negative message for economic prospects. The PBoC could be moving towards easing policy despite a surge in producer price inflation.

Monthly changes in money and lending aggregates were notably weak in April. Six-month growth rates of narrow money, broad money and broad credit fell again, sustaining a downward trend since Q3 2020 – see chart 1.

Chart 1

Trends are weaker in real terms because of a recovery in six-month consumer price inflation. Six-month real narrow money growth is the lowest since February last year – chart 2.

Chart 2

The monetary slowdown was the basis for a forecast that the economy would lose momentum in H1 2021. Q1 GDP growth was below consensus and PMIs have moderated since late 2020. Further monetary weakness suggests that that the slowdown will extend through Q3, at least.

There is little reason to expect money / credit trends to revive. Average interest rates on bank loans have moved sideways since Q3 2020 – chart 3. The PBoC’s Q1 bankers’ survey reported a fall in loan approvals, consistent with a decline in the Cheung Kong Graduate School of Business corporate financing index – weaker readings imply less favourable credit conditions.

Chart 3

The expectation here was that the PBoC would reverse its H2 2020 policy tightening in response to softer economic data and an ongoing money / credit slowdown. The central bank, however, was concerned about housing market strength in early 2021 and withdrew liquidity to reverse a decline in money market rates into late January.

Many continue to expect the next PBoC move to be a tightening, a forecast seemingly supported by a recent surge in producer price inflation. The latter, however, has been driven by raw material costs, with little pass-through to date into producer prices of consumer goods – chart 4.

Chart 4

Core consumer price inflation has recovered from early year weakness but remains low – chart 5.

Chart 5

The weak April money / credit numbers could be the trigger for a PBoC rethink. Three-month SHIBOR has been allowed to drift slightly below its January low – chart 6. A further decline would support the view that a policy shift is under way.

Chart 6