The bumpy last mile

The Chief Economist of the European Central Bank (ECB), Philip Lane stated in a recent interview that “central bankers aspire to be as boring as possible”. This may be an accurate generalisation; however, the life of a central banker has been anything but boring in recent years.

The initial spike in consumer prices in 2021 which was initially viewed as ‘transitory’, proceeded to breach 9% on a year-over-year basis in the United States (US), Eurozone and the United Kingdom at the peak in 2022. Central bankers suddenly found themselves playing catchup, and reacted by ratcheting up interest rates, at a pace not witnessed since the 1980s in the US. Despite refraining from waving the victory flag just yet, global central bankers will be discreetly marvelling at their achievement of bringing inflation back to today’s more amenable levels.

The drivers of inflation have shifted

Generous fiscal relief in the United States during the pandemic bolstered household demand for physical goods and commodities (yellow bar in Figure 1) at a time when supply chain bottlenecks limited the availability of these goods. Price inflation of physical goods, which had been falling on average since 2000, skyrocketed.

Today with supply chain bottlenecks largely alleviated, the driver of US inflation has shifted. Approximately 90% of US headline inflation is driven by core services. Inflation in this sector is closely correlated to employee wage growth, due to the labour-intensive nature of the services sector.

In contrast to the US, energy inflation accounted for approximately 40% of headline inflation in the Eurozone at its peak in September 2022. A combination of energy and food contributed two-thirds of headline inflation, while this figure was closer to half of UK inflation at its peak. Europe’s vulnerability to an overreliance on Russian gas became apparent, resulting in higher gas and electricity prices for households and businesses. In contrast, the US has benefitted from its self-sufficiency as a net exporter of natural gas since 2017.

Given the significant discrepancy in drivers on the way up, it is no surprise that inflation’s journey back down has varied widely by region.

Confidence is a fickle thing

To date, there have been few bumps in the road in the fight against inflation in Europe. Just as energy inflation was a key driver on the way up, moderating energy prices have helped to provide enough comfort to the ECB to implement their first rate cut in June, ahead of the Bank of England and US Federal Reserve (Fed).

In the US, despite significant progress, the first quarter of 2024 provided a reminder that the fight against inflation is not a done deal. Getting the annual rate of inflation rate from 9% to 4% proved to be quite straightforward. The last mile of the journey from 4% to 2% (the US Fed inflation target) has proven to be more challenging.

In March, the US Fed Chair Jerome Powell informed the Senate Banking Committee that the Fed was “not far” from gaining the confidence it needed to begin cutting interest rates. Only two months later in May, there was a clear shift in narrative. Powell noted that his “confidence is not as high as it was” for inflation continuing to move lower. There were several reasons for this shift including:

• Accommodation rentals is the largest category in the US Consumer Price Index (CPI) at ~36% of the overall index. The equivalent categories in the Eurozone and the UK are less influential (Rentals are ~15% & ~8% weights respectively). Although rental costs in the US have slowed to +5.4% in May, having peaked above 8% in the first quarter of 2023, the pace of this disinflation has disappointed.
• Motor insurance: the year-on-year change in motor vehicle insurance costs reached a new high above 20% in the most recent CPI print. Car prices and repair costs are two key leading determinants of motor insurance costs, and both surged following the onset of COVID-19.

A second wave of inflation?

Taking a glass-half-full perspective, the two areas of concern above are lagging indicators (with various seasonal factors) and are expected to stabilise or move lower in coming months and quarters. Although we cannot completely rule out a second wave of US inflation that forces the Fed to revert to interest rate increases, the probability of this scenario remains low.

A second comfort for global central bankers is that their credibility remains intact. A useful barometer of central bank credibility is how successful they are in controlling and anchoring inflation expectations. Consumer surveys on both sides of the Atlantic indicate that inflation is expected to be below 3% in three years’ time.

Central bank divergence

The variances in regional consumer price index components, pandemic fiscal supports and the levels of energy dependency have all played a part in the diverging paths that central banks are expected to follow when cutting interest rates. The ECB’s first rate cut in June is likely to be followed by the Bank of England, and then by a more gradual Federal Reserve possibly by the end of the year.

What does it mean for investors?

Investors are naturally concerned about the potential spillover effects into economies and financial markets. For instance, will relatively higher for longer interest rates in the US mean that global currencies will depreciate versus the US Dollar? It is important to remember that markets are forward-looking and a divergence in policies is already priced into a certain extent. What could have an impact on financial markets is a widening or narrowing of these divergences versus what is currently anticipated.