The baton passes from inflation to growth
It has been our contention for some time that the focus of financial markets will switch from inflation to growth and then onto debt. In recent months the focus of markets has been somewhere between the first two: still concerned about core inflation and where inflation will eventually settle, and at the same time becoming increasingly worried about economic growth because of the scale of monetary policy tightening in recent years.
This has been the case in the US, UK and across the euro area. The release of better inflation data this week than the market expected in the US and UK has been the latest trigger for attention to switch more to the outlook for growth. With it, there is now an increased focus on when policy interest rates will fall. 2024 looks set to be the year of falling (but not collapsing) policy rates across the western world as growth worries come to the fore.
The US sets the tone
Market sentiment is, naturally, driven by the US. At the last FOMC meeting, the Federal Reserve voted to leave rates unchanged, between 5.25% and 5.5%. Since then, the jobs data has been consistent with a slower pace of growth, and the consumer price index (CPI) has seen a more moderate pace of inflation.
On a month-by-month basis, US CPI rose by only 0.1% in May, 0.2% in June and 0.2% in July before rising sharply by 0.6% in August and 0.4% in September. Thus, no change in October was welcome for the economy and markets. The annual rate of CPI is now 3.2%.
The Fed’s 2% inflation target is based on personal consumer expenditures (PCE), and the annual rate of increase of the PCE deflator is 3.4%. But both the CPI and PCE measures look set to decelerate, consistent with our view that we are in a disinflationary environment (see August 3rd, ‘Disinflation will be the buzzword for markets’).
Meanwhile, excluding food and energy, core CPI is up 4% and the core PCE deflator is up 3.7%. Such figures, plus the noisiness of many of the components of the inflation indices, means the Fed is unlikely to adopt a dovish tone just yet. Indeed, latest data is consistent with the Fed’s view that while inflation will decelerate it will be elevated. The Fed therefore remains cautious.
At the time of the last FOMC meeting they still had a bias to tighten, but given the latest data I still think it is more likely they leave rates unchanged and thus that the Fed funds rate has peaked.
In the wake of the better-than-expected CPI data, the question for the markets is when will the Fed start to ease? Since the days of Alan Greenspan, markets have become used to monetary policy being the shock absorber for the US economy. This has become a trend elsewhere, too, in the wake of the 2008 global financial crisis.
Surely, though, the challenge for central banks next year is to balance the need to allow rates to ease slightly as they respond to the disinflationary environment, while accepting that policy rates must – and should – settle at a higher future level than before the pandemic. This will form part of the debate in coming months: avoiding a return to cheap money and the problems associated with it, while identifying where the future level of neutral interest rates may be.
The markets are fully pricing in the first US rate cut around May, and a total of four cuts next year to reach around 4.25% by the end of 2024. Meanwhile, they are pricing in the first UK rate cut of 0.25% by June, falling to between 4.5% and 4.75% by year end. This is understandable.
The nature of the inflation shock in the US has been different from the UK and euro area, with more of an impact in the US from the strength of domestic demand and a relaxed fiscal stance. The underlying story, though, is the same and is consistent with our comments for some time now. Inflation has peaked, it is set to decelerate sharply, and will likely undershoot 2% targets during 2024 before settling at higher levels from 2025 onwards, probably around 3% or so.
Importantly, over the last quarter century global factors have been a major driver of lower inflation in western economies. But two of the four main global factors have changed. So while we are still in a disinflationary global environment because of intense international competition, those pressures are less intense than before.
The four global drivers keeping inflation low were: globalisation, the squeeze on wage shares as unions lost power, financialisation (growing prominence of the financial sector) and technology. The last two are unchanged. If anything, AI will reinforce disinflationary pressures. But the first two have changed.
Globalisation has been replaced by fragmentation, as firms don’t just base location decisions on costs, but on other factors, including risks to supply chains. Subsidies are playing a bigger role, too. The net result is friend-shoring (growing trade links between allies) and on-shoring.
Globalisation, in turn, had squeezed wages, particularly but not exclusively in low-skilled roles. Wage shares had also been squeezed by previous de-unionisation in western economies. Now the changing climate has seen wage shares start to recover. This is welcome news in many respects, although it adds to central bank concerns about second-round inflation effects, and helps explain some of their vigilance, more so in the UK than in the US.
Global factors are critical but so, too, is monetary policy. For instance, the surge in UK inflation was triggered by both supply-side factors and poor monetary policy. Both of these have now been reversed.
UK rate cuts back on the agenda – but not for some time
On the positive side for the UK economy is that as inflation decelerates further, wage growth will provide a boost to real incomes. Wage growth is now outstripping inflation for the first time in this economic cycle. Of course, the picture varies across income groups and is also impacted by savings. High post-pandemic savings have helped cushion the cost-of-living impact for some, but excess savings have largely been depleted.
Also, while inflation will decelerate, price levels will remain high. This may impact expectations as surveys suggest many people think falling inflation will mean falling prices. This is not the case. Petrol prices, though, could fall if softness in oil market pricing continues.
Despite this, the economic risks are to the downside in the UK. The economy is stagnating and recession is possible. The economy grew 0.3% in Q1, 0.2% in Q2 and was flat in Q3. Monthly GDP data was up 0.2% in September after 0.1% in August. There were some pockets of strength, with professional and financial services up solidly in both August and September for instance – but in contrast consumer-facing services were weak, down 0.2% in September and down 0.7% in August.
There are three negative factors weighing on UK growth prospects:
- The composite Purchasing Managers’ Index of 48.7 in October (while above September’s 48.5) is still in recession territory.
- Money and credit growth is negative. The Bank of England’s measure (excluding intermediate other financial companies) showed that in September, M4 lending was down 2.7% year on year and M4 monetary growth was down 4.2% year on year. These are consistent with recession.
- The impact of previous monetary tightening has yet to feed through fully.
Immediate attention will be on the imminent Autumn Statement. As we discussed last week, with demand sluggish and inflation pressures easing, there is a case to help demand with income tax-cuts. Yet the Chancellor’s immediate focus may be on measures to help the supply-side of the economy, for instance, by making full expensing permanent for firms.
Notwithstanding the Autumn Statement, the latest economic data reinforces our thinking that UK policy interest rates have peaked and that rate cuts will be necessary next year. The economy will likely receive another fiscal boost in the March Budget and inflation should undershoot its 2% target by the summer.
Monetary policy has already moved from too loose to too tight. But the Bank will be uneasy about cutting rates too early, for fear that inflation will reignite. That’s understandable. So a period of rate stability is likely. We have factored in UK rates falling from 5.25% to 4.75% in the second half of next year. This backdrop suggests that the bear market for bonds is over.
Please note, the value of your investments can go down as well as up.
