I’ll tell you about the little games between central banks and inflation

1 July 202310 months ago babelfish

Inflation and central bank moves remain under observation. Here because. The analysis of Tiffany Wilding, Economist and Managing Director of PIMCO

Resilient labor markets and falling energy prices in the first half of 2023 look set to give way to a more uncertain growth environment as the impact of tighter monetary policy and tensions in the banking sector they will be heard. Unlike last year, when inflation was uniformly sticky with upside surprises, it is starting to diverge across countries and sectors. While some central banks are making initial progress towards reducing inflation, central bankers continue to face a difficult balancing act.

Outlook for June: the key points

Without fiscal policy ready to salvage the situation, we see a more uncertain growth environment, with increasing downside risks over the cyclical horizon. We continue to expect that a US recession and rising unemployment will eventually kick off a cycle of central bank policy normalization, but not before some more global central bank hikes in developed markets, including the US Federal Reserve, in the coming months.

Initial conditions

Since our last Cyclical Forum in March, falling energy prices and resilient labor markets have contributed to a reacceleration in real household income growth and service sector activity across developed markets. These growth spurts have kept inflationary pressures elevated, especially in the UK and Japan, where indicators of sticky inflation have accelerated. However, the rise in interest rates also contributed to the banking sector stress wave of mid-March, which manifested itself mainly in the United States, although Europe (with the Credit Suisse bankruptcy) was not immune. Government efforts to limit contagion have mitigated the risk of imminent and severe economic consequences; however, the increase in banks' cost of capital and the persistence of the sector's stock market shock, especially in the United States, will probably weigh on growth over time.

Outlook: Growing uncertainty and downside risks

After the re-acceleration of the first half has largely subsided, a more uncertain growth environment is expected, with increasing downside risks. The reasons are many:

Central banks in industrialized countries appear to be offsetting some of the positive momentum in the first half year by raising interest rates somewhat more than expected. In the US, we believe the Federal Reserve is almost certain to hike again in July and that another hike is likely later in the year. In early June, the Reserve Bank of Australia and the Bank of Canada restarted their hikes, saying inflation is still too high and policy is not tight enough. Last week, still accelerating UK inflation prompted the Bank of England to hike by 50 basis points and signal more to come, despite mounting evidence of a slowing labor market. Finally, the resilience of the labor market and the acceleration of unit labor cost inflation in the Eurozone represent a problem for the European Central Bank , despite the weakness in manufacturing activity.
These further hikes by central banks come against a backdrop of already tight financial conditions, tightening bank lending conditions, and falling demand for loans, all of which are likely to slow down economic and labor market activity with some lag . The United States, with its fragile regional banking sector, appears particularly vulnerable.
China posted very strong growth in the first quarter, but its momentum after the reopening of COVID already seems to be fading. Losing momentum in consumption growth, with an already weak export sector and a fragile housing market, requires more government support. However, any short-term credit or fiscal easing in China is likely to be targeted and modest.

Inflation trends are likely to remain uneven

Divergent inflationary trends are likely to continue across product subgroups within regional consumer price indices, in contrast to 2022, when inflation surprised relentlessly in one direction across products and regions. Barring a further rise in geopolitical tensions, headline inflation is likely to continue to moderate in all regions, as the sharp appreciation in energy prices seen last year exits the year-on-year calculation.

Product price inflation is also expected to moderate as production bottlenecks ease, the supply of goods increases and input costs fall. However, we expect wage and services inflation to be slower and require a weakening of the labor market to achieve price stability. This is consistent with our view that moving US inflation from 9% to 4% would happen relatively quickly, while returning inflation to the Fed's 2% target would take longer and grow slower . Other developed markets will likely face similar challenges in taming inflation.

Differences between regions are also likely to persist. For example, we are more confident that US core inflation will moderate in the second half of this year, as rental easing and the more recent drop in used car prices are reflected with some lag in official government measures . However, inflation dynamics in the UK and the eurozone still appear to be lagging by a few quarters, due to currency shocks and energy prices, while less flexible labor markets mean wages are likely to have to adjust further to reach the prices. Indeed, inflation in the UK and Japan is still accelerating.

Finally, it's worth noting that China appears to have the opposite problem. Inflation is down and some of the disinflation or outright deflation is likely being exported to the rest of the world via a weaker Chinese currency. As global demand for goods shrinks, China may also try to stabilize export growth by increasing the supply of cheaper Chinese products in global markets.

Central banks are still in a difficult position

In general, central banks are balancing weak progress on the inflation front – a lagging indicator – with fading growth momentum amid a daunting macroeconomic outlook. This equilibrium implies further risk of rate hikes in the next quarter or two, in our view, than markets currently price in, followed by downside risk in 2024. Basically, we expect developed market central banks to issue more a couple of hikes over the next few months and then keep policy in tight territory. We believe the Fed could be the first major central bank to cut in 2024, as the rising unemployment rate and contracting activity moderate the inflation outlook.

All of this is happening as fiscal policy fatigue continues to take hold. Barring more severe recessions in developed markets, we don't expect much support from fiscal policy over the cyclical horizon. The easing of the energy shock in Europe and the UK should also tend to moderate targeted fiscal measures, while US fiscal policy in the second half of 2023 is likely to become a real headwind – By our estimates, restarting payments of student loans and tax deadlines that had been deferred could represent a $100-150 billion annual headwind for US consumers, which will likely erode savings and shrink household budgets. Meanwhile, the uncertain prospects of tighter regulation for medium-sized banks should further slow loan growth.

In conclusion

Our June consultations did not change what we identified as the key investment themes for this year: in short, focus on the high-quality areas of the bond market where starting yields are high. In our view, this can help investors build resilient portfolios in a more uncertain and volatile macroeconomic environment.

This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/inflazione-banche-centrali-cosa-succede/ on Sat, 01 Jul 2023 05:01:15 +0000.