Macro update - January

Macro update prepared by Rokas Grajauskas, Danske Bank Chief Baltic Analyst

Reflation hype. A deja-vu from 2017?
‘Optimism’ has permeated market sentiment at the start of the year so far, with, notably, equities off to a strong start and oil prices are on the increase on Iran unrest-related supply worries and a US cold snap. Further, the enactment of the US tax reform, coupled with a continued stream of decent data releases across regions, has made for a revival of the ‘reflation’ hype that similarly grabbed markets at the start of 2017.
Is the ‘reflation’ story for real this time round? We doubt it. The ‘reflation’ case was strong in the US at the start of 2017, less so for the euro area – but during the course of 2017 it failed to materialise, partly as a result of fading beliefs in ‘Trumponomics’. Little has changed with respect to the eurozone inflation story as well.
Albeit the global economy is set to stay on a strong footing, subdued wage demand (except possibly in the CEE region) and downside risks from China will keep inflation and central-bank normalisation at bay globally. Our business-cycle models suggest that the cyclical outlook remains upbeat across regions in the short term but that momentum on a 3-6M horizon is wearing off in, notably, Europe, while it is set to stay intact in the US. While this points to an environment benign to risk assets at the start of the year, we do not see any significant game-changers for the global inflation outlook this year.

Inflation expectations in the US have increased again lately

5y5yInflation expectationsSource: St. Louis FED, Macrobond, Danske Bank 
When to expect the next FED and ECB rate hikes?
Several members of the ECB Governing Council have indicated that the ECB should not extend its QE programme after 2018 and that the first hike can come as early as Q1 19. With ‘reflation’ still set to be long in the waiting for the Eurozone, we believe such ECB expectations look excessive. Although the unemployment rate is slowly inching downward, it is still not enough to kick start the Eurozone-wide process of more significant wage growth and inflation. We maintain our opinion that the ECB will deliver its first 10bp deposit rate hike in Q2 19. With wage growth and core inflation expected to move gradually higher, the second 10bp deposit rate hike is likely to come another six months later in Q4 19.
Meanwhile, near-term FED pricing has been upped recently. A March hike is now priced with around 72% probability, which is a bit stretched in our view. Our base case is still for the next hike to be in June. This said, FED policy is highly uncertain at present. One thing is that new Chair Jerome Powell is set to take over and new members are entering the Board. Another is that the FED seems increasingly inclined to shift from the current regime of inflation targeting to price-level targeting, which could potentially lead to a more dovish FED. However, what is set to drive markets near term in our view is the strong hold on which the US is entering the year. Thus, the pricing of a March hike could be sustained if US data continue to keep the US ‘reflation’ trade alive near term.

The FED will continue its gradual hiking cycle in 2018
The FED will continue its gradual hiking cycle in 2018Source: Bloomberg, Macrobond, Danske Bank
Unemployment continues to edge down in Latvia
The unemployment rate in Latvia continues to edge down. According to the latest data, in November it fell to 8.1%, the lowest level in the post-crisis period.
Despite the downward trend, Latvia still has the highest unemployment rate among the Baltics. This has been largely due to weak job creation. The level of employment reached its peak in 2013 and since then has been on a general declining trend. The key force pulling down unemployment is shrinking labour force, which has been on the decline ever since the 2008-2009 crisis. Labour force is shrinking due to negative net migration, low birth rate and population ageing.
In Q3 employment growth inched up marginally, thus pushing unemployment more strongly down. The sectors where employment expanded most were construction, professional services and public administration. The sectors with the most negative employment growth were agriculture and manufacturing. Interestingly, despite the negative demographic trends, the public sector during the last three years has added most jobs to the labour market. In other words, the share of public sector workers relative to the total size of the population has been increasing lately and in Q3 17 reached the highest level since the Soviet times.
In the last several years falling unemployment has been the key factor behind higher wage growth, which increased to 7.5% in 2017. As the economic cycle moves upward, domestic businesses will be confronted with two forces working in the opposite direction – on the one hand, more expensive labour force will negatively affect employment growth, on the other hand, more buoyant domestic demand with encourage business to hire more people.
We expect the unemployment rate in Latvia in 2018 to average 8.1% and fall to 7.6% in 2019.

Employment growth turns positive
Employment growth turns positiveSource: Macrobond, Danske Bank