Global Monthly - The inflation comeback?

• While this apparent setback warrants vigilance, we think the turnaround in labour markets and the slowdown in wage growth is likely to keep the broad disinflation trend in tact

• We continue to expect inflation in the US and eurozone to be back near 2% by the end of 2024

• Also this month: We update our recession heatmap to reflect the latest macro developments

Global View: Inflation is poised for a rebound, but softening labour markets will prove more important

The inflation genie – which looked like it might be put back in the bottle after all – now seems poised to spring one last fright on financial markets over the coming months. The recent rally in oil prices, combined with a bottoming out in a number of other key disinflationary trends, is expected to drive a near-term rebound in inflation in the US, and a slowing in the decline in eurozone inflation compared to recent months. Does this mean we are going to be stuck with persistently above target inflation? Will central banks have to do even more to get rid of it? In this month’s Global View, we explore the drivers of the unfolding inflation comeback, and we also lay out a more negative alternative scenario to see how bad it could get. Our conclusion is that any rebound in inflation is likely to be much more shallow than the 2021-22 inflation surge – more dead-cat-bounce rather than back-to-square-one. Core to this view is the clear turnaround in labour markets we have seen over the past year. The exceptional tightness in labour markets of the post-pandemic period is now rapidly easing, and unemployment is already rising in some countries. This weakening in worker bargaining power is likely to limit second round effects on wage growth, meaning that any inflation rebound is unlikely to last very long.

What is going on with oil prices, and how does this impact the inflation outlook?

Oil prices have rallied over the past few weeks, driven by a number of factors. In particular, the announcement by Saudi Arabia and Russia pledging to extend voluntary reductions in output until the end of 2023 have put upward pressure on prices, with WTI crude hitting 90 USD, a 10 month high. The Saudi/Russian supply cuts helped offset increases in production in Iran on the back of a relaxation in the enforcement of some US sanctions, and Nigerian output rose following the restart of its Forcados terminal. Brent has already reached $95 per barrel, but we think that the price will average $90 for Q4 of 2023, driven by the expected slowdown in the US economy and the normalization of China demand which has already taken place (post-reopening). For 2024, we expect the price to average 95 as resurgent Chinese consumption, along with record low global inventories and the aforementioned supply shortfalls are expected to tighten the market further.

Higher oil prices feed rapidly through to petrol pump prices in both the eurozone and the US, and for this reason we have upgraded our near-term inflation forecasts, as described below. However, the medium-term impact is more uncertain and depends on other factors. On the one hand, higher oil prices could raise consumer inflation expectations, which as we saw during the energy crisis in Europe, could cause wage earners to demand ‘inflation correcting’ pay rises. But with labour markets now softening and with the direct impact of the oil price rise set to be much smaller than the surge in natural gas prices last year, we think there will be less scope this time around for second round effects on wage growth. If anything, by raising the cost of essentials and eating into disposable income, higher petrol prices could curb spending in other areas, leading to more disinflationary pressure in other inflation categories such as in discretionary goods and services.

Eurozone: Headline inflation to take somewhat longer to fall back to target

We have upgraded our forecasts for eurozone headline inflation for the rest of this year and the first months of 2024, but have kept our outlook for core inflation roughly unchanged. The upgrade to our year-end forecast for Brent crude means there will now be less of a negative contribution from overall energy inflation (of which a large part is natural gas prices). Assuming year-ahead TTF gas prices of EUR 55-60 per MWh over the coming year, and Brent at USD 90-95 per barrel, the contribution of energy to total HICP inflation is now forecast to be close to zero for the rest of the year (our previous forecast assumed a -0.5pp contribution on average). This contribution is likely to turn positive again in the first months of 2024, gradually rising to around a 0.6-0.7pp contribution in the second half of next year. In a more negative scenario, where oil and gas prices were significantly higher (TTF at EUR 110 per MWh in 2023, EUR 150 in 2024, and Brent at USD 110 per barrel in 2023-24), the energy contribution would rise to around 2.5pp by the middle of 2024. Even this more negative scenario would still see headline inflation overall continuing to decline, however.

Another key driver of our forecast upgrade is food inflation (see also Box 1). Previously, we expected food price inflation to become negative in the final quarter of this year and to remain negative in the first half of 2024. While we still expect food price inflation to decline markedly, we now expect it to stay slightly positive. Recent extreme weather as well as geopolitical factors (such as uncertainty surrounding the Ukrainian grain deal) are expected to keep food prices relatively elevated. Although some food commodity prices have fallen in recent months, we think the high degree of uncertainty over future food commodity prices will likely make producers reluctant to pass on these declines for fear of getting caught out by any renewed spikes in prices. Indeed, the drop in the food commodity price index since the spring of 2022 (by around 25%) has so far not resulted in any monthly declines in the seasonally adjusted HICP food price index. Taking both food and energy together, we have raised our headline inflation forecasts by 0.5pp for 2023 to 5.7%, and by 0.1pp for 2024 to 2.3%.

Despite the slower pace of disinflation we now expect in headline inflation, our forecast for core inflation – a much more important driver of the interest rate outlook – is essentially unchanged. We still expect core inflation to move gradually lower over the coming year, and to be close to 2% by mid-2024, for two reasons. First is the ongoing economic weakness. We expect eurozone GDP to contract moderately or be close to stagnant for the next few quarters, which should also result in a rise in unemployment and lower wage growth. The services sector, which grew robustly in the first half of this year and has trailed the contraction in industry, is now clearly slowing. This should limit wage growth in the sector, and strengthens our conviction that services inflation will slow. Next, both goods and services inflation should decline further as the impact of last year’s energy crisis continues to peter out, and weak demand will prevent companies from passing on the renewed rise in energy costs to consumers. Taken together, our forecast for core inflation remains at 5.0% in 2023 and 2.2% in 2024.

US: Headline inflation to rebound temporarily, but underlying disinflation to continue

Higher oil prices have also led us to upgrade our US inflation forecasts, by 0.1pp to 4.2% in 2023, and by 0.2pp to 2.8% in 2024. Unlike in the eurozone, we expect the jump in oil prices to trigger an outright rise in inflation over the coming months – not merely a slowing in the disinflation process. This is because headline inflation had already fallen to relatively low levels in the US in recent months, with a recent trough of 3% in June. Inflation has since picked up to 3.7% in August, and we expect a further pickup to 3.9% by December. Aside from a higher contribution from energy, we also expect the disinflation in core goods to ease in the coming months, with for instance the declines in wholesale used car prices having come to an end. We also expect the negative drag from medical services inflation of the past year – which was driven by a statistical quirk related to the pandemic and the way this category is calculated – to normalise, meaning medical services will once again contribute positively to inflation. It is important here to note that, for the Fed’s preferred inflation measure – PCE inflation – medical services is calculated in a different manner to the CPI, and so has not been subject to this same distortion. As a result, the pickup in PCE inflation is expected to be more moderate than that in the CPI, with a peak of 3.5% expected by December, vs 3.9% for the CPI measure.

The bounce in headline inflation is likely to prove short-lived, however. After peaking in December, we expect inflation to resume its downtrend, as the expected stabilisation in oil prices coincides with further disinflationary dynamics in services inflation. The biggest driver of this is likely to come from housing rents, or shelter as it is referred to in the CPI. Shelter has a very large weight in the US CPI at around 1/3 of the total basket (the equivalent for the eurozone is just 6% of the HICP basket). With the jump in housing rents during the pandemic, shelter has been one of the more durable drivers of the post-pandemic inflation wave. Due to the way this component is calculated, the response to actual changes in rents for new leases is with a very long lag. As such, there is significant disinflation from the past year still to come through to the CPI and PCE data, even though recent new lease rents are starting to pick up again. We expect this disinflation to continue as we move into 2024, which should help overall inflation to continue to trend lower. All told, we expect CPI inflation to fall back to 2.3% by December 2024, and PCE inflation to fall back to 2.1% – essentially returning to the Fed’s 2% target.

What could a more negative scenario for inflation look like? Assuming a further pickup in oil prices, such that WTI crude averages $105 per barrel in 2024, and less pronounced disinflation in housing rents (for instance if the recent pickup in new lease rents is sustained), this could see inflation peaking higher at 4.3% in December, with a return to the Fed’s 2% target not taking place before 2025. As with the eurozone, even this more negative scenario would still see the disinflation trend broadly continuing, just at a slower pace than in our base case.

Softening labour markets are ultimately key to inflation falling back to 2%

Central banks typically ‘look through’ inflation upturns driven by oil (and other commodity) prices, and for good reason: most of the time, these episodes are short-lived and do not lead to sustained rises in inflation. The recent past is likely to make central banks tread more carefully this time around, given the risk that above-target inflation becomes more persistent. With that said, we think central banks are likely to draw greater comfort from the recent softening in labour markets. The reason the post-pandemic inflation wave proved to be more persistent than expected was that it came against a backdrop of very tight labour markets, which gave workers the confidence to bargain for pay rises that corrected for the inflation surge. These pay rises then fed through to services inflation, which is now the dominant driver of above-target inflation in most advanced economies.

However, this backdrop is now quickly changing. Economic growth has slowed sharply in the eurozone (see Box 2), and in some countries – notably Germany – this is already driving a rise in the unemployment rate. In response, wage growth looks to have peaked, and it cooled sharply in Q2. In the US, although economic growth has been more resilient, there has been a turnaround in the labour market, with job vacancies plummeting over the past year, jobs growth slowing sharply, and wage growth that is now running very near the pre-pandemic pace. We judge that these softening labour market dynamics will have a bigger influence over the medium term inflation outlook than the rise in oil prices. While the inflation comeback certainly warrants vigilance, it is unlikely to alter the broad disinflationary trend.

links above: May Global Monthly; we dropped; here