Last mile in fighting inflation could be complicate.

The final stretch in the fight against inflation could well be much more complicated than initially anticipated. It is difficult to predict what will happen. Disinflation seems to be stagnating. Basically, there is a tightening of monetary policy and an easing of fiscal policy that are contradictory. Even the best economists will find it difficult to apply their models because the elements are so divergent and complex, and the combinations of factors unprecedented.

Disinflation is slowing

As disinflation begins to stagnate in the USA, the markets are anxiously scrutinizing the reaction of the central banks. Hopes of a rapid rate cut are fading, with consequences for investors and the current US President's chances of re-election. What had often been predicted seems to be slowly coming true. In the fight against rising prices, the final straight is proving rather winding. After stern central bankers quickly succeeded in bringing inflation down from peaks of 9 to 10% in 2022, largely thanks to falling energy prices and the normalization of supply chains, it is stabilization that has set in over the last few months. And at a level above the 2% target.

Sticky inflation returns

The fact that the monthly US inflation figures have been higher than expected every time since the start of the year is making the markets increasingly nervous. Stock markets recently reacted sharply to the announcement of March's disappointing figures. Both equities and bonds fell, as persistent inflation reduced the chances of a rapid cut in interest rates. In the EUR zone too, the fight against rising prices is running out of steam, albeit to a lesser extent than in the USA. European inflation is still moving in the right direction, but at an increasingly slow pace. And the target has not yet been reached. The brutal interest rate hikes by the ECB and the US Federal Reserve to cool the economy and inflation do not seem to be enough for the time being. This suddenly undisciplined inflation has resurrected the idea of sticky inflation. By this term, economists refer to the phenomenon whereby prices do not move quickly enough in response to changes in supply and demand and tend to continue rising.

Services sector in the spotlight.

The services sector is particularly exposed to this, as wages account for a large proportion of costs. Wage increases, which are a (belated) compensation for the fall in purchasing power, weigh heavily on costs, which can force service providers to raise their prices again, thus perpetuating the cycle (the famous inflationary spiral). This explains why persistent inflation in the services sector - 4% in the EUR zone - is still preventing the ECB from sleeping soundly.?

But in the meantime, sticky inflation has become a generic term by which observers mean that inflation is more persistent - literally "sticky" - than expected. Whatever the cause. JPMorgan has warned that the huge amount of government subsidies in the US, as well as the need to invest in the green economy and defence, among other things, could lead to stickier inflation and higher rates than expected.

Where has Goldilocks gone?

These rate expectations are a key driver of the financial markets. They are supposed to be a sign that the central banks are about to cut interest rates, which would in turn give the economy some breathing space. The "Goldilocks" scenario is the ideal outcome. In this scenario, central bankers would manage to bring inflation down to 2%, without doing too much damage to growth, after which interest rates could be cut again and the party could continue the markets.

Ideal scenario

Except that persistent inflation is jeopardising this ideal scenario. The question now is whether central banks should do more, for example by keeping their rates at current levels for longer than expected (4% for the ECB deposit rate, 5.25% - 5.5% for the Fed Funds rate). One more pressure point for the economy, then, to ensure that it cools down, including in the labour market, which is still remarkably robust. The very low unemployment rate in the USA and the eurozone, which has been at an all-time low of 6.5% for the past year, is helping to keep wage growth (too) high.?

This persistent inflation is becoming a serious problem for the markets. Last year in the US, we were expecting 6-7 rate cuts, and today we are expecting no more than 2. We are even wondering whether the Fed will cut rates at all. Rising prices for coffee, cocoa, oil, copper and gold are not helping either.

Patience risks running out.

The market rally has been driven by hopes of rate cuts. Patience with rate cuts could run out. Inflation seems difficult to control in the USA. The Inflation Reduction Act (IRA) and US stimulus policies seem to be more numerous and more vigorous than in Europe. Our fiscal policy is much less expansionary than in the US. For some, central banks should not start panicking. Current inflation is not dramatically high. The economy is doing well, at least in the USA. Instead of cutting rates, shouldn't we be stabilizing them? The current situation still seems to be a success, doesn't it? ?

Mind the gap

So, the question is whether we are favoring 'vibes' over 'facts'. There is also an electoral issue at stake in many jurisdictions, including the USA. Whatever happens, the US will set the pace and the ECB will follow... It needs to pay attention to the interest rate differential. We don't know what will happen to interest rates. However, we can accept that it will be one of the most important factors in 2024 (if not the most important) and that it will determine what our economies look like for the next 12 to 24 months. Maybe we're not in a fairy tale or a nursery rhyme like Goldilocks. Perhaps we are living through a new situation that economists cannot grasp as they would like to. It is up to us treasurers to adapt, as we always do, and to prepare ourselves for an environment of high interest rates and a “Table Mountain”, for some time to come.

?

Fran?ois Masquelier, CEO of Simply Treasury – Luxembourg 2024 April. ?

Disclaimer: This article was prepared by Fran?ois Masquelier in his personal capacity. The opinion expressed in this article are the author’s own and do not necessarily reflect the view of the European Association of Corporate Treasurers (i.e., EACT).

?

?