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What’s keeping the inflation up?
Key takeaways:
- There’s still a long way to go to get inflation back to comfortable levels. Several January inflation releases in major economies surprised to the upside. We do not think they portend a reacceleration, but they challenge hopes of a smooth return to target.
- The risk for policy rates is still skewed toward higher for longer. Fixed income markets are now better priced for the long road ahead. However, we do not expect cuts from any major central banks this year. Equity markets look rich relative to a ‘higher for longer’ scenario.
- The longer inflation stays too high, the more central banks should feel the need to prompt economic weakness, sooner. This would imply a higher risk of policy-driven recessions.
Core inflation is still too high, despite tentative signs of a peak. Run rates of core inflation have generally fallen in recent months but remain uncomfortably high. The run rate of US core personal consumption expenditure (PCE) inflation has been essentially flat since May 2022 at an annualized rate of 4%–5%. Eurozone core inflation has been stuck at a similar run rate since October, having declined from a September high.
We do not think the strong January inflation releases in the USA and Eurozone portend a reacceleration of inflation. However, they challenge hopes of a rapid return to central bank targets, even considering the possibility of seasonal adjustment issues in the US January data.
Source: Credit Suisse, Haver Analytics
Inflationary pressure is still too broad
Although inflation breadth has narrowed, well over half of price categories are running above a 2% annualized rate in the major economies. The reduction of this measure in the USA is more convincing than in the Eurozone and UK and is likely to continue to fall faster.
Source: Credit Suisse, Haver Analytics
US inflation is mainly a services story, Europe has wider problems
In the USA, overshooting inflation is now predominantly driven by services, particularly shelter. High-frequency indicators on prices and rents suggest US housing inflation will decline, but the Federal Reserve is now focused on non-housing services inflation, for which disinflation has stalled.
Europe has a broader problem. The recent decline in Eurozone headline inflation has been heavily driven by energy prices, while food, goods and services inflation remain too high. Europe’s lagged process of wage adjustment to past inflation implies that the wage component of services inflation may be sticky for some time. The UK faces high inflation on all fronts. In contrast, Japan’s overshooting headline inflation is driven almost entirely by food and energy. Core inflation remains below target (as shown in Figure 1).
Source: Credit Suisse, Haver Analytics
Still a way to go on wage growth
For inflation to durably decline to target, wage growth should have to slow. Key wage measures appear to have declined from highs in the USA and Eurozone, but still stand far above pre-pandemic averages. We believe wage growth in the UK and Japan is yet to peak.
The risk for policy rates is still skewed toward higher for longer
We expect the decline in inflation to remain gradual and bumpy. Headline and core inflation are likely to remain comfortably above target in the major economies through 2023. Fixed income markets are now better priced for the long road ahead. However, we do not expect any cuts from any major central bank this year.
Source: Credit Suisse, Haver Analytics
Takeaways for investors
Investors should not count on a rapid pivot by central banks toward more expansive monetary policy. Recent inflation data out of Europe raises the risk that the ECB may have to do more than originally thought, and that the terminal rate could be significantly higher than 3.5%. Investors should hence think hard about the sustainability of the equity rally year to date. The equity risk premium is outright unattractive. Current valuations do not reflect the new higher-for-longer interest rate regime, and earnings will not show an improvement versus last year but rather a deterioration. Instead, bond yields now offer attractive entry points in anticipation of an eventual victory by central banks over inflation. And for the doubtful, US inflation-protected government bonds now offer 1.5% real yields for 10-year maturities plus full compensation for inflation.
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Monthly “90 seconds with” podcast: September 2023
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