Inflation’s sharp slowdown across advanced economies has created a stand-off between markets and central banks over when borrowing costs will edge lower.
To one side are central bankers warning it is too early to do a victory dance in their fight for stable prices, while on the other investors are already celebrating by betting on how soon interest rates will be cut.
The course of inflation will be crucial in determining which side is proved right. Several factors, such as flattening energy prices and strong wage growth, threaten to delay policymakers’ mission to complete the “last mile” of bringing inflation down to their 2 per cent target.
Germany’s central bank president Joachim Nagel this week warned of “a bumpy road ahead, with ups and downs in inflation over the near future”.
Investors are pricing in the first quarter-point rate cuts by both the US Federal Reserve and the European Central Bank by June, followed by a further two or three cuts over the remainder of 2024. The Bank of England is expected to move later, lowering rates for the first time by August, with one or two further cuts to follow before year-end.
Those expectations, measured by pricing trends in swaps markets, have emerged despite rate-setters’ repeated warnings that rates will remain high throughout next year.
On Thursday eurozone data is expected to show inflation slowed from 2.9 per cent in October. Economists at UBS and Barclays forecast it will ease to 2.6 per cent this month, down more than three-quarters from its peak just over a year ago and tantalisingly close to policymakers’ goal.
However, ECB president Christine Lagarde said last week it was premature to “start declaring victory” against inflation, warning it was set to reaccelerate “in the coming months” as recent disinflationary forces fade. Isabel Schnabel, her colleague on the ECB board, has compared the next part of disinflation to the final stage of a long distance race.
Nagel forecast eurozone inflation would return above 3 per cent as energy subsidies that have kept a lid on prices are withdrawn.
Most economists agree. They expect eurozone inflation to surge back up to 3.5 per cent in December and still be above 2 per cent until at least the start of 2025, according to the average of forecasts compiled by Consensus Economics.
Other central bankers have also deployed sporting metaphors to damp enthusiasm over slowing inflation and rebuff questions about when they will start cutting rates.
Using the term for a deceptive basketball move, US Federal Reserve chair Jay Powell said this month it would not be “misled” by a few months of encouraging price data, pointing out that “inflation has given us a few head fakes” in the past. On Tuesday, Christopher Waller, one of the Fed’s most hawkish policymakers, signalled that rates were unlikely to rise further and could be cut if inflation continued to slow, but his views on possible rate cuts remain fairly isolated among policymakers.
Headline US annual inflation eased to 3.2 per cent in October, after accelerating since June. But it is expected to remain above 3 per cent until January 2024 and slow to only 2.4 per cent by the end of that year, according to Consensus Economics.
Jonathan Haskel, an external member of the BoE’s Monetary Policy Committee, warned this week that labour market pressures and low productivity growth left little scope to cut UK interest rates “any time soon”.
UK inflation reached 4.6 per cent in October, down from a peak of 11.1 per cent a year ago, but the BoE expected it would only ease to 3 per cent by the end of 2024, taking a further year to reach 2 per cent. “We’re more worried [than independent forecasters] about persistence,” said BoE deputy governor Dave Ramsden last week.
Several factors might make it a long slog for advanced economies to bring inflation down to the crucial 2 per cent level.
One is the steep downward correction of energy prices from their surge a year ago after Russia’s full-scale invasion of Ukraine has almost worked its way through the data. Year-on-year declines in consumer energy prices have played a big role in dragging down the headline rate of inflation. In the US, energy prices fell 4.5 per cent year on year in October; in the eurozone they were down 11.2 per cent.
But this impact is expected to fade as annual energy inflation flattens out and could even turn positive again. Food prices have also been slowing for several months. Eurozone food inflation peaked at 17.9 per cent in March and is expected to fall below 7 per cent in November.
The slowdown in inflation has been “rapid because of base effects, but what comes next is certainly slower in the making”, said Samy Chaar, chief economist at Lombard Odier. He added that this was “the same story everywhere”, even if disinflation started earlier in some emerging countries and then appeared in the US, followed by Europe.
Another important element central bankers have identified as likely to keep inflation elevated is the rapid growth of wages, which pushes up costs for labour-intensive services companies that pass it on via higher prices to customers.
This was underlined by ECB data on eurozone negotiated wage growth last week, showing it accelerated to 4.7 per cent in the third quarter from 4.4 per cent the previous quarter. This confirmed the “picture of still-sticky underlying inflation” that would “embolden ECB policymakers to stick with their hawkish stance”, according to Claus Vistesen, economist at Pantheon Macroeconomics.
Driven by rising wages, services inflation in October was 4.6 per cent in the eurozone, 5.1 per cent in the US and 6.6 per cent in the UK. The BoE expected services inflation to remain above 6 per cent until spring 2024. “Services is a very labour-intensive part of the economy and it is going to take longer to get down,” said Ramsden.
JPMorgan economists last week forecast core inflation, which excludes energy and food prices, would remain at about 3 per cent in the global economy through much of next year “largely because of continued upward pressure on labour costs and service prices”.
Also keeping inflation elevated is the withdrawal of government support measures to shield consumers and businesses from the impact of the pandemic and the energy crisis.
France has reduced its subsidy on electricity prices in recent months, which has already sent energy inflation higher. Germany is in January due to reverse a reduction in value added tax on restaurants from 21 per cent to 7 per cent that has been in place since the pandemic. The higher German tax will add 0.6 percentage points to overall German inflation, according to Tomasz Wieladek, chief European economist at investor T Rowe Price.
While the last mile may be the slowest for rate-setters and investors, Chaar said the falls in headline rates mean households will feel better off as wages finally catch up with the surge in costs.
“It means that there [will be] some form of purchasing power next year,” said Chaar.
Additional reporting by Tommy Stubbington in London