We are in a rather sticky situation
It was always likely to be the case that inflation had peaked last autumn, especially as a mild winter helped energy prices fall back sharply. However, central bankers were worried that inflation might become rather sticky, and the latest data from the USA and UK suggests that might indeed be the case. Together with recent employment figures, this backdrop suggests that interest rates might stay rather higher for longer than had been priced in even a few weeks ago.
In the UK, headline inflation did ease for the third month running, to hit 10.1% from a year earlier. There was good news that core inflation was lower than expected, slipping below 6% for the first time since last June. However, the Bank cannot yet be certain about a definite trend, as there was a significant discounting in the New Year sales. In addition, warning lights are flashing about price rises in various sectors such as housing and utilities, recreation and culture, plus health care.
On its own, the markets might have looked on the bright side, but statisticians also reported that a tight labour market – unemployment remains below 4% – meant that pay growth rose 6.7% year on year. This was up from 6.5% the previous month, and its highest level, outside the period of the pandemic, since at least 2001. While private sector wage growth remains strong, lagging public sector wage growth is understandably playing catch-up.
A poll carried out by Reuters has found that the majority of respondents expect the Bank of England will raise interest rates next month for the last time in the current cycle. Nevertheless, economic evidence to support a rapid decline in rates is just not being seen.
A similar situation was seen in the USA. Statisticians reported that US inflation had moderated from 6.5% in the year to December to 6.4% in January. However, deeper analysis of the data by the Atlanta Federal Reserve bank again showed that various parts of the inflation report were sticky, with core inflation remaining above 6% on one of its measures. On the basis of current information, the Cleveland Fed forecasts that headline inflation in the year to February will only ease to 6.2%. As one analyst summed it all up “this report gives Fed officials their talking point for the month ahead of the next FOMC meeting (March 22nd): stay the course”. Whilst some US based economists continue to expect that the US economy can achieve the fabled soft landing, others remain rather concerned about the outlook. In-depth analysis of such issues as global supply chains, energy costs, wages reflecting current employment trends, and corporate pricing behaviour, all point to various problems along the inflation chain.
When is the last Fed rate hike? A recent survey of fund managers suggested it will be in May. Even if interest rates do decline into 2023-24, however, the pullback may not be too great. Market expectations for the long-term official interest rate have risen to about 3.5%, the highest for a decade. This ties in with the latest quarterly Survey of Professional Forecasters’ consensus prediction that US core consumer price inflation looks set to remain above the Fed’s target. The long-established University of Michigan survey of consumer long-term inflation expectations sends the same message.
The ECB is also expected to act again on interest rates in the spring. Despite weak economic activity at the end of last year, the EU raised its growth forecast for the eurozone to 0.9% this year, up from its forecast of 0.3% growth made last November. “Employment in the euro area has been incredibly resilient in face of the economic consequences of the war”, said the chairman of the finance ministers. “Overall, these forecasts point to a euro area that has maintained its resilience, despite the incredible economic shocks of recent years”. Like the other central banks, the ECB is ready to pause and reassess the situation for the second half of the year. Bank of Italy Governor warned that “given the levels of private and public debts that prevail in the euro area, we must be careful to avoid engineering an unnecessary and excessive rise in real interest rates”. Nevertheless, interest rates continue to rise “in a progressive but measured way, on the basis of the incoming data and their use in assessment of the inflation outlook”.
To sum up, central banks are expected to undertake only a few more interest rate hikes, but financial markets are beginning to accept the argument from central bankers that sticky inflation does mean rates higher for longer rather than sharp cuts in the second half of the year.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.66 4.08 3.86
UK 3.83 3.47 3.56
Germany 2.88 2.55 2.50
Andrew Milligan is an independent economist and investment consultant. This note is offered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making