Unpicking inflation trends in a changing rate cycle

Key takeaways

• Despite strong US consumer price index (CPI) figures, the disinflationary trend continues, as reflected in other measures of US and global inflation
• We cannot rule out another supply shock driving inflation higher, perhaps linked to geopolitical risks. A demand-related shock seems less likely, especially outside the US
• We see the Federal Reserve (Fed) cutting rates by 75 basis points (bps) this year, the European Central Bank and Bank of England by 100 bps each and the Swiss National Bank by a further 50 bps
• We reiterate our strategy of locking in current attractive sovereign bond yields. We keep equities at strategic levels and retain a portfolio overweight to the US dollar.

The US consumer price index is defying a broader price normalisation globally. We still see US interest rate cuts in the second half of 2024, with Europe, Switzerland and the UK moving first. Geopolitical risks remain high, but with limited inflationary consequences for now.

What is happening to US inflation? A third consecutive high consumer price index (CPI) reading has delayed interest rate cut expectations further, and even raised the possibility of a hike. From pricing in six or seven rate cuts at the start of the year, markets now expect just one or two in 2024. Persistent services inflation is fuelling concerns that the headline CPI figure has stalled a percentage point above target. ‘Core’ services inflation even reaccelerated in March.

A delayed normalisation?

Some trends in recent CPI figures may be a delayed normalisation from pandemic-era shocks. Housing costs were slow to move up in official inflation measures after rents for new tenants skyrocketed during the pandemic. Now that inflation of rents for new tenants has fallen sharply, the change may again just be slow to show up in official inflation indices. Car prices also rose sharply as parts were hard to source during and after the pandemic. Now services costs around cars, including insurance, may just be playing catch up.

Meanwhile many other important components of US inflation, including food, are falling, and goods prices are firmly in deflationary territory. CPI is also something of an outlier among US inflation measures. The March Producer Price Index (PPI) came in slightly below expectations. Recent personal consumption expenditure (PCE) data, which is the preferred index for the Federal Reserve (Fed), has also been around a full percentage point below CPI, both in terms of headline and core measures.

Watching wages closely

One crucial measure being watched by developed market central banks is inflation linked to wages. Here we see a normalisation underway. While the US labour market remains very strong – with many new jobs being created and low unemployment – it is nevertheless rebalancing. Average hourly earnings are declining and the number of people quitting their jobs is holding steady slightly below pre-pandemic averages. The labour force has been expanding and productivity rising. All four indicators of US wage growth show it falling to a 3-4% range. This level is consistent with headline inflation around the Fed’s 2% target.

Should we fear a second wave of inflation? On the demand side, this would require either persistent fiscal or wage growth drivers. The latter is slowing, and the former is unlikely to reach the heights of pandemic-era aid packages and initiatives including the Inflation Reduction Act, Chips and Science Act, Infrastructure Investment and Jobs Act and the American Rescue Plan Act.

Assessing geopolitical risks

On the supply side, another shock, linked perhaps to geopolitical risks, cannot be ruled out. Beyond a high-stakes scenario of broader military escalation in the Middle East, we see two obvious channels for these risks to affect inflation: upward pressure on energy prices, and additional disruptions or re-routing in global supply chains. On the former, we note that significant spare oil production capacity in Saudi Arabia and the United Arab Emirates, and more limited capacity in the US, could be deployed to offset any short-term oil price disruptions. We have previously discussed geopolitical risk scenarios for oil prices here. 

We also note that global supply chains are already being redrawn in a way that reflects national imperatives to de-risk, secure supplies, and to trade and invest with allies. The Middle East contains three major chokepoints for global trade: the Strait of Hormuz, the Suez Canal, and the Bab al-Mandeb Strait. While historically, conflicts in the region have had few implications for global investors, a major escalation that draws in powers outside the Middle East remains a significant risk. Yet an extension of existing conflicts and ‘bloc logic’ remains our working assumption.

And while current rises in energy prices make headlines, unless a spike here derails consumer expectations of future inflation (which are relatively steady for now), the Fed will not be inclined to react. While we remain alert to signs of a major supply disruption or labour market reacceleration, neither is our base case.

Rates to fall in the second half

Still, solid demand in the US economy may mean stronger services inflation for longer. It also reduces the urgency for the Fed to cut rates. We still see core PCE inflation falling to an average of 2.7% in 2024, allowing for some monetary easing this year. We expect as many as three cuts of 25 basis points (bps) in 2024, dependent on incoming data – not just inflation, but also the strength of the jobs and housing markets, with an eye also on any signs of strains in the financial sector. The Fed will, if possible, want to avoid cutting rates immediately prior to the presidential elections, for fear of being dragged into political arguments. This may argue for a first cut in July if the data is favourable.