Central banks and markets are facing difficulties in achieving victory over inflation.

Mon Apr 01 2024
Ray Pierce (820 articles)
Central banks and markets are facing difficulties in achieving victory over inflation.

Central bankers are having a tough time with inflation in the US and Europe, and investors are starting to wonder if they are being overly bullish about the global economy because inflation is sticking around longer than predicted.

The simple positives include the normalization of commodity prices, particularly for energy, and the ease with which advanced nations’ inflation rates have declined from highs of about 9% to 10% in 2022.

However, the “last mile” is more challenging. According to JP Morgan’s estimates, underlying inflation, which does not include energy and food price fluctuations, rose to 3.5% from 3% in the second half of last year across developed nations.

Because of this, investors are reconsidering their wagers that inflation will fall gradually to the 2% objective set by central banks. Some are worried it may soar again, just like the second wave of inflation in the 1970s.

According to a note by JP Morgan, economists and central banks are relying on “strong gravitational forces that are not yet validated in global labor costs, short-term expectations, or in recent signals from commodity markets” to predict that inflation will continue to plummet. It pointed out that while goods prices had declined last year, they are currently going up, and that inflation in services is still significant.

Officials from central banks have stated that they anticipated a rocky last stretch of declining inflation. Also, they’re showing that they’re prepared to wait before lowering interest rates. The recent surge in global economies and markets started when a small majority of Federal Reserve officials restated their plans to slash interest rates three times this year. Fewer or no rate cuts would have far-reaching consequences for these sectors.

U.S. Commerce Department data released on Friday showed that the Fed’s preferred measure of inflation, the price index of personal-consumption expenditures, increased by a moderate 2.5% year-over-year, up slightly from 2.4% in January. The trend was less reassuring beneath the surface. In the three months leading up to February, the index that does not include food and energy rose by 3.5% on an annualized basis, which is an increase from approximately 2% at the end of previous year.

Speaking Thursday before the most recent inflation statistics was released, Federal Reserve governor Christopher Waller stated, “These shorter-term inflation measures now tell me that progress has slowed and may have stalled.”.

According to Waller, it is reasonable to delay or limit the total number of rate cuts.

On Friday, Federal Reserve Chair Jerome Powell took a more measured approach, stating that robust economic growth permits policymakers to postpone action until inflation reaches 2%, which may be a sometimes rough road. Is it likely that inflation will continue to rise for longer than two months?Powell stated at an interview at the San Francisco Fed that we will need to wait for the facts to inform us of that.

Near the end of February, Joachim Nagel, a member of the rate-setting committee for the European Central Bank and president of Germany’s Bundesbank, stated that underlying inflation in the Eurozone was still 2 percentage points above than its average from 1999 to 2019.

The danger of falling short of our objective and having to hike interest rates again can arise if we cut rates too quickly or too drastically, he warned. He brought up a new research from the International Monetary Fund that stated that after five years, four out of ten inflation shocks during the 1970s still hadn’t been overcome.

According to figures released on Friday, underlying inflation in Italy rose to 2.4% in March from 2.3% in February. Although headline inflation in France slowed to 2.3% in March, service costs stayed stubborn, increasing 3% year-over-year.

The economy has shown remarkable resilience in the face of the steep interest rate hikes over the last two years. This is particularly true in the United States. On Friday, the Atlanta Federal Reserve reported that their real-time indicator for first-quarter U.S. economic growth increased from 2.1% to 2.3%. According to the Commerce Department, annual consumer expenditure rose around 5% in February when adjusted for inflation.

Paul Ashworth, an economist of Capital Economics, stated that the surprise strength of real consumption indicates that there is currently no urgency to lower interest rates.

Although growth in Europe has come to a standstill since the latter half of 2022, new polls of businesses indicate that things are looking up. In the meanwhile, tight labor markets have contributed to robust job creation across the Atlantic and continued high pay increases. The eurozone’s services-price inflation rate, which has been at 4% per annum since November, is largely attributable to wage growth.

On Wednesday, the European Central Bank will release the inflation rate for the month of March. The European Central Bank has hinted that interest rate reduction from their current 4% level could begin in June, although the exact timing of these cuts is still up in the air.

The actions of central banks might be unintentionally making inflation worse. Global borrowing costs fell and asset values rose as they signaled a shift toward interest-rate cuts last October, which boosted spending.

Further declines in inflation are supported by several circumstances. An influx of foreign nationals into the United States and Europe could limit salary growth.

To counteract the high rate of pay growth, productivity—the amount of production produced per worker—is rising sharply in the United States but not in Europe. But for how much longer than that, nobody knows. The pandemic may have altered Americans’ work habits and technological utilization, but once implemented, these changes are permanent, thus the Fed’s Waller does not perceive this as a factor that will lead to continued productivity increases.

On the other hand, recent increases in oil prices have the potential to increase headline inflation.

As a result of China’s massive increase in exports and manufacturing capacity to compensate for a falling real estate market, global goods inflation has taken a hit. However, JP Morgan reports that its export prices have been on the rise as of late.

Governments and businesses already burdened by debt would face more strain if central banks respond to persistent inflation by restraining their interest rate cutting policies. That might put central banks’ resolve to bring inflation in line with aim to the test.

Central banks would likely be pressured to tolerate higher inflation in the future years due to higher government expenditure on defense and renewable energy as well as geopolitical tensions that hinder global trade, according to a March research issued by the Brookings Institution.

The report, written by Harvard University economist Kenneth Rogoff and three other writers, argues that a more credible public debt strategy and a stronger independence of central banks are likely necessary.

Ray Pierce

Ray Pierce

Ray Pierce is a Senior Market Analyst. He has been covering Asian stock markets for many years.