Stumbling To New Inflation Fight Phase

Transcript

Inflation is falling, thanks to lower energy and goods prices.

And last week, major central banks seemed to signal that they are now entering phase two of their rate hike cycles.

1) Phase two in the inflation fight

Phase one was about raising rates quickly and sounding as if they’d do whatever it took to bring down inflation.

We saw them pausing and shifting their message to be more nuanced in a second phase once the damage of rate hikes came into view.

2) Mixed messages from central banks

Last week brought some mixed messages from central banks.

That could be a subtle sign that they are stumbling into that second phase a little sooner than expected.

We believe a pause in rate hikes is now nearing. And that reinforces our view of mild recessions this year.

3) Labor markets to keep inflation high

Labor markets will be key to this.

We see worker shortages in the U.S. and Europe keeping wage growth and inflation high, even amid weak economic growth.

Inflation is set to linger for longer above central banks’ 2% targets.

And although no longer rising sharply, we expect interest rates to stay higher for longer in this next phase for monetary policy.

That’s why we like high-quality credit and short-term government bonds for income.

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Central banks are stumbling into a nuanced phase of policy tightening after major macro events last week. Lower energy and goods prices are pulling down overall inflation. Yet, tight job markets should keep wage growth above levels needed for core inflation to fall to 2% targets, reflected in a 54-year low for unemployment in the U.S. We see central banks close to pausing hikes: major economies will see mild recessions but lingering inflation. We like short-term bonds and credit.

Wages key for core inflation

Notes: The chart shows annualized quarter-over-quarter inflation of U.S. personal consumer expenditure (PCE) services inflation excluding energy services and the U.S. Employment Cost Index measure of annual private sector compensation.

Last year, major central banks took a “whatever it takes” stance on inflation. We saw this as phase one of their policy response in a new regime. We thought they’d one day pause their hikes and shift to more nuanced messaging when economic damage became clearer, then live with some inflation – phase two. Last week’s mixed messages imply they’re stumbling into phase two sooner than we thought and before the damage is fully clear – but we’re not there yet. Inflation is cooling, but it’s not on track to return to target. Some supply disruptions that fed inflation are resolving, and falling goods and energy prices are lowering headline inflation. The outlook for labor markets and wages is key now. We see a shortage of labor in the U.S. and Europe keeping wage growth (yellow line), inflation in the wage-sensitive services sector (orange line) and overall inflation persistently higher.

Headline inflation, including food and energy, has been falling as consumer spending returns to services from goods. Core services inflation will drive overall inflation as spending normalizes, with the labor market central to how phase two plays out, in our view. Central banks seem to think wage growth can fall with headline inflation as workers dial down demands for pay raises to keep up with prices. The Bank of England (BOE) did so explicitly in forecasts last week, implying a deep recession isn’t needed to get inflation to target. Recent job data has been sending inconsistent signals. Notably, Friday’s data showed a still-tight labor market that could keep wage pressures high, notwithstanding recent softer data from ECI and payroll firm ADP. We think wage growth could be more persistent: It reflects a tight job market, difficulty hiring and low unemployment.

Signs of the phase ahead

Signs the Fed is stumbling into phase two: Chair Jerome Powell made inconsistent statements after the Fed hiked 0.25% last week. Powell made clear in his scripted remarks that rates will rise, the Fed isn’t eyeing rate cuts and its job to fight inflation isn’t done. He also stressed that services inflation – the Fed’s main focus – has not shown signs of falling. Yet, his unscripted responses sent mixed messages. Powell failed to push back against easing financial conditions that work against the Fed’s efforts to bring down inflation. He also seemed to imply the Fed’s December economic forecasts were stale. While perhaps unintentional, this disconnect suggests the Fed may be nearing a pause, making communication challenges even trickier.

Other major central banks are facing the same communication challenges. European Central Bank President Christine Lagarde seemed to back down from previous whatever-it-takes language by not repeating that a shallow recession is “not enough” to hit the ECB’s inflation goals. She said the risk of ultra-high inflation had receded and lower headline inflation may lessen wage pressures in nearing annual pay negotiations. The BOE upped its 2023 GDP forecast and lowered its inflation forecast. The ECB and BOE raised rates by 0.5% last week, with the ECB set to do so again in March. The Fed, ECB and BOE pausing slightly sooner would reinforce our view they will face milder recessions this year and live with inflation that’s fallen a lot but is likely to settle above their targets. That means central banks are unlikely to cut rates as markets increasingly expect.

Our bottom line

We like high-quality credit, short-end government bonds and agency mortgage-backed securities for income as interest rates stay higher for longer. We have a relative preference for emerging market stocks. They’ve largely outperformed developed market (DM) stocks so far this year even as DM peers have rallied on hopes of a growth rebound, prompting some investors to jump in for fear of missing out. DM stocks aren’t fully pricing the recession hit we see ahead.

Market backdrop

U.S. stocks rose on the week, shaking off disappointing earnings, while Treasury yields reversed their drop after the Fed meeting. The U.S. jobs data this week brought back expectations that the Fed was set to raise rates further in coming months. We think the key for the market outlook is whether inflation is on track to fall back to 2% targets and whether there will be a recession. Jobs data suggest the Fed has more work to do, even as the market still prices in rate cuts starting later in 2023.

We’re watching China inflation data for the first signs of effects from the economy’s restart after Covid lockdowns. Low inflation has allowed policymakers in China to keep policy supportive – but the rapid restart may prompt a change. China’s total social financing will be closely watched to see how current policy is translating into credit flowing into the economy.