Targeting the Target

• Very good news on US inflation, but the rebound of real wages will help the hawks
• More voices are calling for raising the central banks’ inflation target.
• China needs a stimulus, but the policy space is probably less wide than commonly thought

There was not much to dislike in the US inflation print for June, with all the main components of core going in the right direction. This keeps our hope alive that the Fed’s July hike will be the last one. Real wages need to be monitored though: US employees have been gaining purchasing power again since May. This could re-start consumption, and make the “last mile” of disinflation, down to 2%, more difficult. This is the type of issues which are likely to keep the debate on the post-July trajectory live at the FOMC.

It's unlikely that inflation can completely normalize without a tangible contraction in aggregate demand, and a crucial issue is how deep such contraction needs to go, and whether central banks should tolerate a higher inflation regime, given the potential cost of going all the way to 2%, and lift their target. O. Blanchard had reopened this debate last October, and we hear more voices supporting such a shift. As much as there may be a theoretical case for lifting the inflation target, we think the ramifications for long-term interest rates can be so adverse that it could become counter-productive, e.g., by making the cost of the green transition – one of the forces possibly pushing inflation up – even higher. We are also concerned by the long-term competitiveness impact.

While the West is debating whether 3% inflation would be acceptable, China is dealing with a real deflation trap risk. A stimulus is needed to deal with the current aggregate demand deficit, and the central bank has been operating with much caution so far. Focus is turning to fiscal policy, and expectations are building around announcements which could be made at a Politburo meeting later this month. There are only difficult choices though. The plight of the Local Governments Financing Vehicles is drawing attention to the fact that the policy space is probably less wide than often thought. In any case, China should probably distance itself from its usual approach to stimulus – pouring more capex in the economy – and focus on consumption.