In the United States, economic data surprised to the upside in the second quarter, including data in purchasing managers’ indexes, labor market dynamics, auto sales, and a variety of housing-market metrics. However, food costs contributed positively to inflation, largely because extreme drought in California pushed up fruit and vegetable prices, while cost trends in the housing sector contributed to core inflation levels.
The Fed shrugs off core inflation’s recent rise
U.S. policy tends to look through the food-related cost pressure as it focuses on core inflation, which excludes the volatile food and energy components. Moreover, the Fed uses the PCE (personal consumption expenditure) deflator to measure inflation, which puts a higher weight on medical costs and a lower weight on shelter prices, such as housing, than does the CPI. As an example of this tendency to downplay CPI, Fed Chair Yellen referred to the May inflation data (2.1% headline, 2.0% core) as “noise.” Of course, this overlooks the fact that the May rise in core prices was among the largest in a decade, and double the 10-year average. If one looks at the past 120 inflation observations, the chance of seeing a May-type increase is 5%.
European inflation may bottom out this summer
In Europe, the pattern of real growth is largely flat, despite standout strength in Spain and Germany and renewed weakness in France. The same goes for inflation.
We think inflation in the United Kingdom and the eurozone will bottom during the summer. Potential upward pressure from energy and food prices is something to monitor later in the year. Having said that, the disinflationary threat that prompted the European Central Bank’s recent policy-easing decisions is not likely to go away, in our view, given the region’s nontrivial economic weakness.
Read Putnam's Q3 2014 Fixed Income Outlook on Slideshare or download the complete pdf at putnam.com.