Inflation has tumbled spectacularly across much of the world this year but the job is only half done, even if top central banks are now getting ready to wrap up their most aggressive interest rate hike cycle in history.
The “last mile” in rooting out pervasive price growth is still set to take years, so easing up now appears contradictory to policymakers’ message a year ago that public trust required bringing inflation back to target quickly, even if that meant inducing a recession.
Yet, as global central bankers gather in a mountain lodge in Jackson Hole, Wyoming, for their annual economic brainstorm, talk is shifting to keeping rates around where they are now – but for longer than perhaps previously estimated – rather than raising them further.
The aim would be to ensure a soft landing of the economy even if price growth remains high, possibly throughout 2024.
On the face of it, the shift seems justified, given the striking progress on inflation. Price growth was around 10% in much of the developed world late last year and now stands at roughly half that rate, with further drops already baked in.
But this is happening while the job market remains exceptionally tight on both sides of the Atlantic, an economic paradox that is leading some to question if inflation is falling regardless of monetary policy – not because of it.
The labour market was expected to soften, taking pressure off wages but businesses are just not shedding workers as expected, partly because they enjoy still-high margins and for now can afford to retain skilled labour.
“When inflation is falling but unemployment is stable or falling, the Fed can’t be sure that its policies are effective,” said Steve Englander, head of G10 currency research at Standard Chartered. “It may just be lucky that a global demand slump or non-policy related domestic forces are driving inflation lower.”
NO JOB LOSSES, YET
U.S. unemployment has been flatlining at around 3.5% most of this year, and the euro zone rate is at an all-time-low of 6.4%. Meanwhile, in places like Britain, Australia or New Zealand, the rate is slightly up from recent lows but still well below historic averages.
The problem is that serious disinflation without a labour market shakeout is inconsistent with standard economics and past experience. U.S. inflation, for instance, has fallen 6 percentage points in the last year from above 9% to around 3%; the last time inflation fell by anywhere near as much – in the early 1980s – unemployment soared to above 10%.
This disconnect led the German central bank to issue a warning to peers this week that a tough task may still lie ahead for policymakers.
“The impression took hold that inflation rates will nonetheless persist for longer above the rates targeted by central banks,” the Bundesbank said. “In particular, the ongoing high wage pressures could make it harder to press ahead with curbing inflation.”
Yet there is little appetite left to hike rates much further, a feeling that will only grow if measures of economic health deteriorate, as they have in Europe.
The Bank of England still has some way to go, but the Fed and the ECB appear to be debating whether just a single more hike is still needed. The Reserve Bank of Australia and the Reserve Bank of New Zealand, for their parts, may already be done.
This is raising some doubts about the resolve of policymakers as inflation is set to remain above target through 2024 and possibly into 2025, the end of the current forecast horizon for many.
“Markets do not trust the ECB to deliver to the 2% inflation target … markets are pricing the ECB to accept an inflation overshoot,” Piet Haines Christiansen at Danske Bank said.
Indeed, longer-term inflation expectations for the U.S. and the euro zone remain above the banks’ 2% targets.
But if there is no appetite to raise rates much further, possibly inducing a recession and a labour market shakeout, then rates have to stay high for longer.
Philip Lane, the ECB’s chief economist, may have previewed this approach recently when he argued the goal is not to curb demand but to limit its growth.
“The trick for us is basically to make sure demand does not add on supply,” Lane said in a podcast. “So it’s not a question of driving demand deeply negative. It just has to grow more slowly than supply.”
CONCERNS ABOUT CHINA
The biggest source of uncertainty that is likely keeping central bankers awake at night is China’s quickly fading outlook, a development nearly as surprising as the pain-free drop in inflation in the developed world and a probable subject of discussion this week in Jackson Hole.
Once expected to buttress global growth in a post-pandemic rebound, China’s economy is now suffering on all fronts and the People’s Bank of China has already cut rates to stimulate growth.
“Externally, China is suffering from declining foreign trade. At home, its property sector remains imperilled, the yuan is suffering from bouts of deflation, and it increasingly cannot generate enough jobs for its graduates,” Niels Graham at the Atlantic Council said.
The government unveiled a batch of stimulus measures this summer, from boosting auto and home appliances consumption, relaxing some property restrictions to pledging support for the private sector, but economists reckon that much more will be needed.
Much of China’s pain stems from a property sector that has been exhibiting signs of stress for the past two years. The key worry is that any prominent failure in the sector could raise the risk of contagion to the financial market and could then spread more broadly.
But even in the best case, weaker growth will reduce demand for imports and complicate the global outlook.
“The lack of a stronger stimulus response partly reflects a greater tolerance for economic weakness,” Julian Evans-Pritchard at Capital Economic said. “But it also points to a worrying degree of policy paralysis, which suggests that the downturn could persist for a while longer.”
(Reuters)