How inflation and interest rates will go in the US and in Europe
What are the prospects for inflation and monetary policies in 2023? The analysis of Jeffrey Cleveland, Chief Economist of Payden & Rygel
The US inflation data released last week confirmed expectations for 2023: a slowdown in inflation is, in fact, widely expected and seems to have already been priced in by the markets. For example, the 1-year US CPI swap is 2.4%, while the 2-year breakeven inflation derived from the TIPS market has already returned to 2.1%.
With core inflation currently hovering between 5% and 6%, the fact that the market is expecting a rapid deceleration in inflation is by no means a wrong expectation. However, history does not provide much evidence of sharp slowdowns in inflation. For example, the last time the Dallas Fed index was up 5% on an annual basis, it then took about 15 years to get back towards 2%.
Even during the Great Recession of 2008, which disproportionately affected the housing market, the CPI of basic services decelerated from 3.3% yoy at the start of the recession to 2.7% yoy after a year of recession.
Inflation expectations in the US
First, we expect deflation for core goods (which exclude food and energy prices). Second, we expect costs for housing services – rents, so to speak – to peak in the second quarter of 2023, and then gradually decelerate towards normal. Finally, we expect non-housing services to remain broadly solid until the labor market actually deteriorates – and, in this case, expectations are for Q4 2023.
As a result, the core PCE will still hover around 4% by the end of 2023. A faster deceleration of core goods, a steeper decline in housing services prices and a sustained decrease in non-housing services prices, however, would change our view.
The moves of the Federal Reserve
Olivier Blanchard, former chief economist of the International Monetary Fund, and Jason Furman, former chairman of the Council of Economic Advisors, argue that the 2% inflation target is not a critical value and that, consequently, the Fed should revise upwards the inflation target.
This new narrative has become increasingly popular among traders throughout 2022, but is struggling to gain traction outside academic circles and among key policy makers. The president of the American Central Bank Jerome Powell, in fact, is not inclined: after the Fed meeting in December he affirmed that this proposal was not even taken into consideration, leaving little room for second thoughts in the immediate future.
The most recent change to the Fed's framework, Flexible Average Inflation Targeting (FAIT), is the result of a multi-year public review process, which usually lasts for years. The next revision is scheduled for 2025: until then, we have to live with the 2% target. But if Fed policymakers, including Jerome Powell, start discussing possible policy revisions or if long-term inflation forecasts are changed, it would lead to a revision of our outlook.
At the moment, the prevailing view among market participants is that the Fed will not cut interest rates until inflation falls below the level of the Fed Funds. The idea behind this narrative is that inflation will not decrease unless the Fed compresses the economy further. This is history to teach us! In no historical cycle – not even the milder one of 2015-2019! – the terminal rate on Federal Funds stood below the annual rate of core inflation.
Will the Fed cease hikes when the federal funds rate is still in negative territory? We are not ready to bet on it. Powell, in fact, declared in early December that the objective is to bring the real rate of the Federal Funds "into positive territory" and keep it "for some time". Payden & Rygel will continue to closely monitor the Fed's language on the real federal funds rate and terminal rate estimates relative to the actual course of inflation. Indeed, these are the two elements that could lead us to change our expectations on the policies of the American Central Bank.
The situation in Europe
As regards the Old Continent, it was often repeated, during 2022, that inflation depends mainly on supply, and that it is driven by food and energy costs.
This is a factor that has led to thinking that inflation may return to normal levels faster than in the US. We, however, do not think that such a deceleration can happen so quickly.
We like to use alternative measures to core inflation, because they exclude outliers to better measure the underlying inflation trend. As shown in the previous graph, the picture appears worrying also – or above all – in Europe, oppressed by food and energy costs. Inflationary pressures have actually spread much wider.
Inflation skeptics also cite low wage growth as a reason to remain optimistic about inflation easing. While falling short of the increases seen in the US, wage growth in Europe has also accelerated, outpacing pre-Covid trends. Only a marked slowdown in trimmed mean inflation (ie, which excludes the goods that have shown the most violent price swings) and a fading wage growth would make us less worried about the European situation.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/inflazione-tassi-stati-uniti-europa/ on Sun, 22 Jan 2023 06:53:33 +0000.