Central banks will find it far harder to eradicate inflation than markets anticipate and will be in no hurry to ease off on rate hikes, argues Ian Pizer.
Read this article to understand:
- Why inflation will be hard to eradicate
- Why central banks are keen to avoid repeating the mistakes of the 1970s
- Why US rates markets look too optimistic
Back in March 2021, Federal Reserve (Fed) chair Jerome Powell said “one-time” increases in prices were likely to have only “transient” effects on inflation. Four months later, he was still defending the idea inflation was likely to prove temporary.
With US annual inflation by now running at a 13-year high, that prompted criticism from several quarters he was underestimating the risks. By the end of the year, with annual inflation having advanced to a level not seen in almost 40 years, all reference to the word transitory had been dropped.
Suddenly, however, financial markets appear to be betting Powell may have been largely right all along. While US inflation has been running at levels not seen since the early 1980s for 15 straight months, it has fallen steadily since peaking at nine per cent in June 2022 (Figure 1).
Figure 1: Consumer Price Index (CPI) inflation starts to fall
Source: Macrobond, Aviva Investors. Data as of December 1, 2023
That has enabled the Fed to slow the pace of monetary tightening. Following a string of 75 basis point increases that began in June 2022, the central bank hiked rates by 50 basis points in December and by just 25 basis points on February 1.
Currently set in a range of 4.50 to 4.75 per cent, US rate markets expect the federal funds rate to peak at just under five per cent. Thereafter, an ongoing decline in inflation is seen prompting the Fed to begin cutting rates as soon as November, with a further reduction priced in for the following month.
This seems optimistic. While headline inflation looks set to continue falling in the coming months, as the impact of earlier increases in energy and food prices falls out of annual comparisons, peering further ahead, uncertainty is greater than at any time in the past four decades.
US core inflation has also begun to decline and seems set to fall further as the impact of higher prices and interest rates continues to ripple through the economy. However, there is a clear risk core inflation proves stickier than anticipated. We see it remaining above the central bank target of two per cent throughout 2023. Moreover, the risks appear tilted to the upside.
Figure 2: Core inflation
Source: Macrobond, Aviva Investors. Data as of December 1, 2023
The picture in Europe is broadly similar. Whereas in the first half of last year inflation appeared to be largely an energy issue, it has broadened out in a comparable fashion to what happened in the US six to nine months before.
Wage pressures building
The key issue is what happens to wages. Central banks spent much of the past decade fearing an acceleration in wage settlements every time unemployment was low. However, time and again the pick-up economic models predicted failed to materialise. This led to the Fed losing confidence in the economic models it had relied upon and was a key reason why it adopted so-called average inflation targeting in 2020. But the exit from COVID-19 lockdowns led to the kind of wage gains the models had been predicting just as the Fed and other central banks had stopped relying on them so heavily.
Market uncertainty reflects differences in opinion on wage pressures
Market uncertainty reflects differences in opinion as to whether wage pressures are a sign the environment has changed and the models can once again be relied upon, or whether this is a one off and wage pressures will abate without the increase in unemployment the models would expect.
To date, there has been little evidence of higher interest rates leading to weaker labour market conditions. This suggests that if unemployment is to rise, the process will be slow. For instance, the US economy added 517,000 jobs in January, three times as many as predicted, driving unemployment to its lowest level in more than half a century.
Wage growth is running at an annualised rate of between five and six per cent and recent settlements show no sign of any meaningful decline. In the UK and euro zone, there are signs wage settlements will be significantly higher this year after workers experienced a big drop in real wages in 2022.
Monetary policy changes typically act with a lag of as much as 18 months before starting to feed into real economic data in a meaningful way. However, there are reasons to believe this process may have speeded up, even if most parts of the economy have yet to feel the full force of the monetary tightening already in place.
When looking at the housing market, US mortgage rates tend to be priced against ten-year bond yields. Although the Fed is still hiking rates, mortgage rates have already begun to fall and there are signs mortgage activity is picking up in response.
No meaningful recession
It is also worth bearing in mind that with most asset prices having recovered appreciably over the past three months, broader financial conditions have also begun to ease. All told, it is looking less and less likely that what the Fed has done so far will trigger a meaningful recession and a material rise in unemployment. Without that, there appears little prospect of it cutting rates.
Has something changed within the US and other developed economies that portends structurally higher inflation?
This begs the question: has something changed within the US and other developed economies that portends structurally higher inflation? Even if it is still unclear precisely what has changed, and whether these changes are permanent, it appears the level of interest rates required to keep inflation in check has risen in the wake of the pandemic.
In the period following the financial crisis, up to the outbreak of the pandemic, it had appeared the neutral level of US interest rates was around zero per cent: unless growth was at or above trend, inflation tended to fell sharply. Now it now seems to be closer to 1.5 per cent; unless growth is meaningfully below trend, inflation will be at or above its target.
One plausible explanation for this phenomenon is the fragmentation of supply chains. The ongoing drive to decarbonise economies is another. It is also possible that with inflation becoming de-anchored from central banks’ objectives for the first time in more than twenty years, inflation perceptions have started to change.
While financial markets want to believe inflation will prove transitory, there are solid reasons they will be proved wrong. With Powell having repeatedly stressed his biggest fear is a repeat of what happened in the 1970s when the Fed sounded the all-clear on inflation, only for it to re-accelerate, rates markets look overly optimistic.
The bottom line is the downside of tightening policy too far to stamp out inflation is smaller than the cost of taking the foot off the brakes too soon. Expect central banks to continue to adopt a risk-management approach to setting policy rates, with the primary focus on bringing inflation down to target, albeit while trying to limit the risk of creating excessive economic pain.
All this is before we consider external factors that could influence inflation. Gas and oil prices might have fallen in recent months, helped by relatively mild weather in much of northern Europe, but the danger of unforeseen geopolitical events leading to a further spike in prices is ever present. Moreover, sanctions on Russian oil are expected to be tightened. That threatens to remove more supply from the market, which other OPEC members may choose not to replace.
The world will continue to fragment, leading to the reconfiguration of supply chains
Uncertainty over China’s economic prospects following the Chinese Communist Party’s decision to abandon zero-COVID, as the policy’s mounting economic costs became increasingly evident, is adding to the difficulty in predicting where inflation in the US and other advanced economies is heading.
On the one hand, the decision to open China’s economy should reduce many of the supply-chain bottlenecks that have fuelled goods price inflation across much of the world since the outbreak of the pandemic. But on the other, increased Chinese consumption is likely to boost energy and commodity imports, pushing up their price. At the same time, there is little doubt the world will continue to fragment, leading to the reconfiguration of supply chains. This process will inevitably be inflationary.
External factors all point to the risk of ongoing inflationary pressures
With external factors all pointing to the risk of persistent inflationary pressures, ongoing strength of the labour market and US rate cuts priced in for later this year, it is hard to understand why the market is so optimistic inflation will be brought under control.
The US inflation-linked bond market is priced for inflation returning to around two per cent by the end of the year, with only marginal moves away from target in subsequent years, despite also pricing in central bank rate cuts. This seems to be calling the all-clear on inflation far, far too soon.