Chinese New Year fuels inflation
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Chinese New Year fuels inflation

In a major blow to hopes that Chinese policy officials would sanction a further easing of financial conditions, inflation in January rose to 4.5% YoY, up from 4.1% in the final month of 2011 and well above expectations. In the month of January alone, prices were up by 1.5%, which represents the largest monthly increase since 2008.

Part of the explanation for the higher rate of prices growth is the distortion from the Chinese New Year, which often triggers a surge in spending. Even so, what will most concern policy-makers is that consumer spending is still so strong, despite a determined regime of tightening over the past eighteen months.

Wages growth in China remains high – last year real disposable income rose by around 10% (in sharp contrast to falling real incomes in most large advanced economies!). Also, the government is lifting the minimum wage by 13% per year until 2015. Although wages growth is still an issue, the slowing in the rate of growth of factory goods prices will please policy officials.

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In January, producer price inflation eased to just 0.7% YoY, down from 1.7% in the previous month. This in turn suggests we could see consumer inflation slow in the next few months. For now, though, Beijing will remain cautious about easing monetary policy too quickly, despite a pronounced decline in property prices. Interest rate cuts are definitely off the agenda for now and bank reserve requirements will be reduced over time, but only gradually. Quite correctly, Chinese officials are still frightened about the potential for the inflation genie to return.


Greek saga will continue beyond deal.   Yet again yesterday, markets were drifting between being captivated by and frustrated with Greece, but even if the positive noises we have heard come to fruition (agreement on austerity and the ECB sharing some of the pain), it’s difficult to see Greece moving that far away from the headlines. There was some interest in an FT Deutschland story suggesting that only EUR 30bln of the EUR 130bln second aid package will be released, with the remainder subject to a parliamentary vote in Germany. This is partly a story and partly not. Remember that the EU/IMF has always paid aid to Greece in instalments. So far, six have been paid, with the largest of these being the initial EUR 20bln back in May 2010. As such, EUR 30bln would be the largest single payment to date, with subsequent tranches dependent on Greece meeting the austerity and other measures set out by the EU and the IMF.   But the fact that Germany wants to impose ever tighter controls on the remaining disbursement will once again make for an even more painful process of securing future funding by Greece. The end of November’s disbursement (EUR 8bln) was delayed for weeks; this one looks to be going right to the wire and, if Germany’s position proves to be as suggested yesterday by FT Deutschland, future disbursements could be even more protracted affairs. If agreement is reached today (a big ‘if’ as usual) and the stories on the effective ECB write-down prove to be true, then no doubt markets will breathe a collective sigh of relief. But don’t expect that to be the end of Greece’s odyssey, as the country continues to live hand to mouth from the EU/IMF bowl.

ECB will buy some time today.   When the ECB meets today it is likely that monetary policy will be a secondary issue to bank liquidity and, most likely, the fate of the ECB’s holdings of Greek debt. The first two issues are linked; while the ECB has already been keen to separate liquidity provision from monetary policy, the fact is that the 3Y auction back in December has allowed overnight interest rates to fall substantially. We are currently seeing overnight rates trade by some 60bp below the 1% refi rate, similar to the discount prevailing in the early part of 2010 when the ECB’s 1Y repos were still outstanding. Still, in terms of funding costs for the banking system, this matters less now given that more banks are sourcing funds from the ECB rather than the market, with that cash remunerated at the average of the prevailing refi rate.   Of more interest will be the ECB’s stance on its substantial holdings of Greek paper (around the EUR 40bln mark) in light of yesterday’s negotiations and the comments from the WSJ that the ECB may be looking to transfer its holdings to the EFSF. If that happens, no doubt some may round on the ECB for changing its previous stance of not participating in any restructuring deal. But, as we wrote last week in our blog (“The ECB will have to yield on Greece”), the ECB is doing the right thing and Draghi is adopting a more pragmatic approach than his predecessor. This is essential for a central bank and a monetary union both sailing through a crisis that neither was equipped to deal with. Markets are likely to welcome this approach.   On the economy, the ECB is likely to reiterate its position of last month, namely that whilst risks remain there are signs of stabilisation overall. This should underpin its desire to hold rates steady and await the outcome of the second 3Y refinancing operation at the end of the month. The success or otherwise of this will be crucial in determining the extent to which the more bullish tone to markets carries through to the end of the current quarter.

More QE from the BoE likely.  Ahead of the ECB, the Bank of England will announce the results of its latest policy meeting. This is crucial for two reasons. Firstly, it’s an inflation report month and historically policy announcements have been concentrated more strongly in these (Feb, May, Aug and Dec).   Secondly, its quantitative easing program, announced back in October last year, has come to an end and the Bank must ask the question of whether it should continue.   We feel it’s more likely than not, but only a further GBP 50bln of bond purchases at most. The Bank is concentrating on buying UK government bonds and this does make the program more limited in contrast with the Fed or the ECB’s programmes of liquidity injections. That said, the recent weakness in the economy (down 0.2% in final quarter of last year) combined with some better forward indicators of inflation suggest the Bank does have the scope for a modest easing of policy.   It’s also worth noting that whilst EUR markets have enjoyed the advantage of the ECB’s substantial liquidity injection, sterling markets have not and this has been evident in the money markets. We don’t expect any new initiatives from the Bank of England on this front, but it’s a point worth keeping in mind, especially as UK banks have their own refunding to be done this year (GBP 140bln of short-term funding to be completed this year).

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