Strategy blog: Peak or plateau?

Incoming data continues to show inflation rolling over even as unemployment remains low.

The good news may not last. Disinflation is clearest in the US; economic resilience is arguably most visible in the eurozone (at least, as gauged by business surveys).

But it could. If the inflation surge was driven by both demand and supply – if it was caused not just by too much spending, but also by bottlenecks and commodity squeezes – then it can subside without as much damage to growth as would be the case if it had been driven only by the former. Unshackled supply, and weakened energy prices, are good for both growth and price stability.

Improved supply conditions are visible in the supply-chain data chronicled in earlier posts, and in the firmer participation rates in the US labour market reports. They are arguably implicit too in the failure of wages to accelerate more dramatically on both sides of the Atlantic.

Of course, this may not be the only cause of the resilience to date. Maybe tighter monetary policy itself is not yet having much impact – real mortgage rates have not risen that far yet, and economies may not be so sensitive to it (see our earlier post on the remarkably-low proportion of UK households facing significantly higher mortgage rates in 2023).

But as European natural gas prices languish at just a fifth of their August highs, one powerful supply-side driver at least is very visible.

What might this mean for interest rates? Having previously mismanaged demand so badly, central banks have some credibility to rebuild, and will not be quickly inclined to interpret economic resilience as benign. And inflation is rolling over, not collapsing: we are still well above target in the States, the eurozone and the UK.

So we should expect to see rates continue to rise – and perhaps to new (for this episode) prospective highs. The money markets have been pricing in some of that in the last week or so.

But how far, and what happens next?

One view is that if the US economy remains resilient, the Fed will simply keep tightening until it does crack. And if it tries hard enough, even the most supply-led economic resilience might be crushed. On this reading, interest rates rise a lot further – but then eventually fall sharply too.

But the Fed is formally charged both with keeping inflation down, and employment up. The latter objective is not quantified, and is implicitly assumed to be the less important in the monetary policy context. Still, the Fed will not deliberately cause a more dramatic economic setback – a material fall in employment – unless it believes that is indeed necessary to pull inflation back down towards target. And it may not be.

So as long as inflation is declining, with little sign of a "wage price spiral", the Fed may instead decide to wait and see – to raise rates further, for sure, by maybe another 50-100bp, but then to pause. A big recession may not be needed.

But the logic of this view is that if ongoing economic growth can indeed coexist with declining inflation, why would the Fed – again, mindful of its credibility – cut interest rates? Similar logic, though in a different institutional context, applies to the ECB and BoE. The interest rate profiles we have in mind look more like plateaus than peaks, and this is where we remain most at odds with the money markets.

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