Softer Inflation Vs Resilient Activity

• The past week featured some more downside inflation and upside activity surprises. Although the former drives short-term policy decisions, we see resilient activity as indicating high neutral rates that truncate the potential for rate cuts later.
• Next week is busier, especially in the UK, with inflation and labour market news. We are again under the current CPI consensus this month, which would fit the global skew in July releases. The on-hold RBNZ and hiking Norges bank take the policy baton.

After our call last month on the BoE-Fed “Icarus Spread” crashed back to earth, the Heteronomics Economics Monthly (HEM) for August needed to highlight another aspect of where we see things differently. Many aspects of our view have become consensus, like the UK’s exceptional issue being primarily a matter of wage settlements. That problem means BoE hikes have further to go, despite the ECB and Fed probably pausing. However, we believe it is premature to extrapolate the turn away from hiking into rate cuts. Resilient activity data don’t justify turning looser, so we see global rate cuts as being slow to a high neutral level (see HEM: Persistent Policy Peaks).

After UK GDP beat expectations again in Q2, we expanded on that view as we recognised the tendency for activity data releases to skew towards surprising resilience. Price and wage inflation drive current policy decisions, but activity is critical to the outlook. The strength of GDP growing near its potential pace means the current effective policy setting doesn’t look that tight. Neutral rates may be near pre-GFC norms. Policymakers can wait for evidence that cyclical excesses have gone before turning to relatively small and late cuts. Policy hysteresis only compounds this pressure (see Resilient Activity Raises Forward Rates).

Surprisingly steep rate cuts in Chile and Brazil last week did not lead to surprises this week in Mexico and Peru. Both central banks kept their policy on hold. A similarly unchanged outcome is expected for the RBNZ next week, while the Norges bank will likely follow through on its guidance for another 25bp rate hike to 4%.

Banco de México’s decision to hold its interest rate reflects a commitment to inflationary control. While Mexico's economy exhibits growth and resilience, challenges persist, with the annual headline and core inflation rates hovering above the target, emphasising the complexities in achieving the 3% target by 2024. However, given the uncertain inflationary outlook and multiple potential risks, maintaining the current reference rate for an extended period appears to be the central bank's strategic choice.

The Board of the Central Reserve Bank of Peru also chose to sustain the reference rate at 7.75%, as expected, influenced by recent declines in inflation rates, though rates remain above the targeted range. While global inflation has surged due to heightened food and fuel prices, forecasts anticipate a steady decline in Peru’s year-on-year inflation, gravitating towards the target range by next year. However, potential climatic risks may pose challenges. Despite a moderate economic recovery in July, the Board remains vigilant and is prepared to adjust its monetary stance based on emerging inflationary data, global economic activities, and potential risks.

The official guidance on policy decisions in the near term is broadly pitched as dependent on the data. That should always be the case, but that is a reference to price and wage inflation in the current environment. Fears of potential second-round effects justify a focus on such data, despite the risk that the headlines leave policy set in an excessively backwards-looking approach. Market pricing has become hyperactive to such data, so the upcoming UK and final EA inflation prints cannot be ignored.

We are below the consensus for UK inflation for the second consecutive month. This time, we forecast the rate to slow by 130bp to 6.65% on the CPI and by 195bp to 8.8% on the RPI (373.3). That is 0.1-0.2pp under the current consensus. However, most of the drop seems relatively uncontentious this month, with the negativity from housing related to regulated energy prices and the food price weakness tracking moderated cost pressures like other countries.

Figure 1: Contributions to m-o-m CPI inflation

Months with household energy price changes have been more prone to surprise, although not with a consistently signed beta to the shock in the UK. Some forecasters may be muddling things again this time because regulated prices didn’t used to change in July, and it straddles a few schemes. The correct recording is the transition from the energy price guarantee (EPG), without incorporating any cash rebates, to the new Ofgem cap. That’s almost a 17% shift. We integrate it using the proper index aggregation formula rather than approximating it with the weighted sum of changes, where most economists probably do it that way for simplicity in their spreadsheets.

Our forecast for a downside surprise seems less outlandish than last month, where that result required breaking a well-established trend to upside surprises. Downside surprises have been widespread in July, including in the US, many Euro area member states (see EA: HICP Slowing Slightly in Summer-23) and Norway. It’s also been a similar story further afield, with upside inflation surprises proving small and rare in July. Falling food and energy prices have often driven the news, and the UK shares some stories in those areas.

The EA aggregate avoided a surprise in the flash estimate after member state releases revealed the soft story. Final releases since then have been mixed, with Spain and France marginally stronger but Italy 9bps weaker. The 5.31% headline seems unlikely to round differently to 1dp either way.

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