Inflation is falling fast, so why are central bankers stalling on interest rate cuts?
Late last month US Federal Reserve chairman Jay Powell gave an upbeat assessment of the fight against inflation, summing up the current situation as “so far, so good”.
At first glance, a positive outlook appears justified. In the US, the inflation rate dropped to 3.4% in 2023, down from 6.5% the previous year. Headline price growth in the Eurozone is currently 2.8%, edging towards the European Central Bank (ECB) target of 2%. The figure in the UK is higher, but at 4% is still half what it was six months ago.
So are central banks on the brink of beating the rampaging inflation that has undermined economies since the end of the pandemic, and lowering interest rates?
The message from many economists is “not so fast”. Nobody is declaring victory just yet, despite the upbeat tone.
In fact, central bank rate setters believe the “last mile” on the road to meeting inflation targets may be the toughest one to travel. With that in mind, the Fed, ECB and others are likely to remain highly cautious in their approach to cutting rates.
Inflation is falling - but for how long?
For now, inflation continues to fall. International Monetary Fund (IMF) figures show that consumer price growth across advanced economies dropped to 4.6% in 2023, from over 7% in 2022. The fund predicts a further fall to 2.6% this year.
“What’s not in doubt is that inflation has fallen significantly since post-pandemic highs, and that downward trend looks set to continue in the short-term,” says John Lorié, Chief Economist at Atradius.
“But what is in doubt is how low it might go. Central bankers have looked below the surface and realised that their 2% inflation targets - and the credibility that comes from meeting them - may not be so easy to achieve.”
Central banks look beyond headline figures and see a contrasting picture. On one side, the declining cost of energy and industrial goods continues to drive significant falls in inflation. On the other, rising wages and geopolitical tensions are beginning to push the other way.
Inflationary pressures are not over
The worry for central banks is that deflationary momentum will begin to wane just as new upside pressures emerge.
Supply chains are pretty much back to normal after pandemic disruption, and commodity prices are dropping as the global economy adjusts to post-pandemic realities and shocks like the war in Ukraine.
The result has been lower producer costs and weakening inflation, but many economists think the impact of these factors will dwindle over the first quarter of 2024.
At the same time, upside pressures mount. The geopolitical landscape remains volatile. Economies have adjusted to the upheaval of the Ukraine war, but conflict in the Middle East is adding a new layer of uncertainty.
Attacks on shipping in the Red Sea by Houthi rebels have already led to a tripling of shipping costs from Asia to Europe, as ships take longer routes to avoid the conflict zone. We think the disruption could add 0.2ppts to US inflation and 0.3ppts to European inflation if attacks continue for six months or more.
That’s not enough to seriously threaten inflation targets on its own, though it may slow progress. But it’s a different story when looking at the jobs market.
The US economy added 353,000 jobs in January, nearly double the expected number. In the Eurozone, the jobless rate remains historically low and wages rose by over 5% in 2023.
While a tight jobs market is good news for workers, it does have implications for wage setting and therefore inflation. A hot jobs market is a particularly big problem for the service sector, where wages make up a larger percentage of total costs. Prices in the sector remain stubbornly high.
More than the troubles in the Red Sea, rising wages could prove a major barrier to meeting inflation targets in 2024.
A contrasting picture
With all that in mind, it’s no wonder that central banks remain cautious. The costs of commodities and industrial goods are falling fast, feeding into lower consumer prices.
But service sector businesses are struggling to fill positions, driving up wages and prices.
Central banks are tightly focused on bringing inflation down to 2% target levels, which is seen as necessary for restoring credibility. Their fear is that rising wage demands and geopolitical uncertainty will make the “last mile” of this journey especially treacherous.
“For these reasons, we don’t expect central banks to change their cautionary approach to rate cuts in the near term,” says John. “After the latest labour market statistics, we think the the late spring is realistic for the first rate cuts to happen. The good news is that the easing of monetary policy is still a question of ‘when’ rather than ‘if’ in 2024.”