Inflation’s gravity check: what goes up, must come down

Key takeaways

• Inflation in the US and Europe is slowing as supply chains recover and energy costs fall. Broader price pressures will take time to normalise as services inflation remains high, but may be contained by late 2023
• The Fed is watching evidence of slower wage growth as it approaches a rate peak of around 5%, possibly in March, while we see another 100 bps of ECB hikes to 3% by mid-year
• We expect any recessions in 2023 to be short-lived and manageable but with Fed rate cuts no earlier than December
• In markets, concerns are shifting from inflation to growth. With capital costs set to remain high for most of 2023, a tilt towards quality across asset classes remains our preference.

Little by little, there are signs that inflation is slowing. Data is confirming that higher borrowing costs are slowing demand while supplies of food and fuel improve. The chances of sidestepping deep recessions in 2023, and then pausing interest rate hikes, are growing. There are reasons to be cautious; still-high inflation and still-rising rates, tight job markets, shifting global logistics and geopolitics all remain unpredictable.

Inflation slowed in December from the US to Germany, France and Switzerland. This does not mean that central banks’ jobs are done in western economies. Inflation was the dominant economic driver of 2022 and prices will keep rising in 2023, perhaps at a slower pace late in the year to bring average levels closer to policymakers’ 2% ‘stability’ targets (see chart 1). In the meantime, central bankers are looking for more confirmation that economies are slowing in response to higher borrowing costs, with slower wage increases and lower demand, before they halt interest rate hikes. The year ahead, as we wrote in November, will be separated into two phases, marked by an end of tightening in the US and a bottoming in growth.

 “It’s clear that we haven’t turned the corner yet on inflation,” Gita Gopinath, deputy managing director of the International Monetary Fund (IMF) told the Financial Times last week. The US Federal Reserve should keep raising rates until there is a “very definite, durable decline in inflation,” she told the paper. Fed Chairman Jerome Powell said last week that the Fed has “more work to do,” and emphasised the importance of its final peak rate, and how long borrowing costs stay high, rather than the pace of the central bank’s hikes. The Fed began increasing its benchmark interest rate in March 2022, taking the target range to the highest level in 15 years at 4.25% to 4.5%. We expect US rates to peak around 5%, perhaps in March 2023, without a first cut until December at the earliest.

The US path to reach that peak is starting to look clearer. Data from the US Institute of Supply Managers (ISM) shows goods delivery times have recovered and demand has fallen. Housing markets have registered lower demand as mortgage rates track rising borrowing costs. However, much of the US’ inflation outlook in 2023 depends on weaker wage growth, while many firms are still hiring. At 3.5% in December, the US unemployment rate is still falling, and at 50-year lows, while shortages of workers continue to push wages higher, though at a slower pace. Wages rose by 4.6% in December, compared with 12-months earlier, the smallest increase since August 2021. Labour market participation remains stable at 62.3%, one percentage point below its pre-pandemic level. 

Global drivers improving

The factors driving inflation lower in the US, are also operating at a global scale. In many economies, goods prices are slowing and the costs of services are decelerating. High post-pandemic demand worldwide met supply shortages that created trade bottlenecks. Global production and logistics have now recovered and supplies in everything from semiconductors to cars have caught up. That is helping inventories and relieving price pressures, which, with some inevitable lag, translates into broader, slowing inflation data.

We expect that declining inflation will let central banks slow, then pause, their interest rate hikes. The IMF expects that tighter monetary policies will trip one third of the world’s economies into recession in 2023. Still, without evidence of major structural imbalances, we think that these should be short-lived and manageable, with the process of recovery kicking-in as early as the second half of 2023.

Warm forecast, with little chance of shortages

In the eurozone, the overriding concern remains energy supplies and prices. While the energy crisis that has accompanied the Ukraine war will keep inflation rising for longer than in the US, government reactions have been relatively swift and coordinated. European policies have encouraged lower consumption and invested in new sources of energy, built inventories and bought liquefied natural gas on global markets. Helped by the continent’s record warm winter weather, gas prices have collapsed back to levels not seen since before the Ukraine/Russia war. European spot gas prices are trading close to EUR 70 per megawatt hour (MWh), almost half their average of EUR 133/MWh in 2022.

Even if temperatures fall closer to their winter averages in the coming weeks, each day that passes equates to lower consumption, saving inventories that are 83% stocked at the moment. That improves the chances that in the longer term, for the winter of 2023/24, the continent can continue to sidestep serious shortages or blackouts (see chart 2).

Falling oil prices have also helped to slow inflation. A barrel of Brent crude has tumbled from more than USD 120 in the middle of 2022 to less than USD 80/barrel today. Over 2023, we see prices settling around USD 90/barrel, which looks consistent with Saudi Arabia’s domestic budget for the year that assumes oil trading at around USD 75/barrel.

Import prices more widely in Europe’s economy have also fallen faster than at any time in six decades. That saw consumer prices in Germany rise by 9.6% in December compared with a year earlier, from 11.3% in November. Inflation in France, the eurozone’s second-largest economy, also declined in December, to 6.7% from November’s 7.1%. Across the eurozone, price rises slowed to 9.2% in December, from a high in October of 10.6%. Wage growth in the region, which rose by less than 3% in the third quarter of 2022, is less pressing than in the US.

Falling inflation is not everything and these are not linear processes. While the European Central Bank slowed its rate hiking pace to 50 basis points in December, taking the benchmark to 2%, the rest of its policy statement last month pointed to a more hawkish outlook. We expect the ECB to raise rates by another 100 bps over the course of 2023, taking its terminal rate to 3%. This said, if European energy markets continue to improve, we cannot exclude the central bank’s rate peaking at a lower level.

Asia’s economies are largely on different paths. In Japan, core inflation reached an historic 3.7% in November, however that has not yet prompted a monetary policy response. Wages are beginning to rise as consumer prices have jumped and the government has provided support for the increased cost of living. China’s central bank on the other hand has continued to loosen monetary policy by easing its reserve requirements to boost liquidity as the country contends with the complexities of stepping away from its Covid restrictions.