'Inflation fever' is finally over — but central banks won't stop raising rates

(Bloomberg) — Global inflation is finally starting to pick up, even if it remains too hot for the world’s central bankers to like.

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As economic growth slows, prices of major commodities – from oil to copper and wheat – have cooled in recent weeks, easing pressure on the cost of manufactured goods and food. And it’s getting cheaper to move these things as supply chains slowly recover from the pandemic.

After the worst price shock in decades, the speed at which relief arrives will vary, with Europe in particular still struggling. But for the world at large, analysts at JPMorgan Chase & Co. estimates that consumer price inflation will fall to 5.1% in the second half of this year – roughly half of what it was in the six months to June.

“The inflation fever is breaking,” said Bruce Kassman, the bank’s chief economist.

This does not mean an early return to the subdued inflation that much of the world enjoyed before the twin shocks of Covid-19 and the war in Ukraine – or an end to monetary tightening in the near term.

The Fed is still moving

Rents and labor-intensive services are likely to continue to become more expensive as the labor market is tight and wages rise. There are also broader forces at work, from slowing globalization to weak labor force growth, that could keep price pressures on.

Major global central banks, which failed to see the pandemic price shock coming, are poised to press ahead with interest rate hikes even as headline inflation peaks. The Federal Reserve, the European Central Bank and the Bank of England are expected to raise interest rates again in September.

Fed Chairman Jerome Powell left the door open for another huge 75 basis point hike next month, telling fellow central bankers in Jackson Hole on Friday that the recent decline in US inflation was “not much less” than what politicians want to see. The following day, ECB Executive Board member Isabelle Schnabel said that “central banks must act decisively.”

Some central banks, which have raised interest rates faster than the Fed, may take advantage of cooling price pressures to pause their tightening.

This month, the Czech National Bank left policy unchanged, while Brazil’s central bank is expected to do the same in September. And New Zealand’s central bank may be nearing the end of its aggressive moves, Governor Adrian Orr told Bloomberg Television from Jackson Hole.

The skyrocketing cost of living has left politicians and central bankers feeling the heat — especially in Europe, where natural gas prices more than seven times higher than a year ago have sparked an energy crisis.

Eurozone inflation is expected to accelerate above a record 8.9% since July, and Citigroup Inc. predicts it could exceed 18% in the UK, partly because the cap on energy bills has just been lifted. All sorts of once-outrageous proposals, from nationalization to power sharing, have been put forward to deal with the crisis.

The U.S., by contrast, will experience the fastest decline in inflation among advanced economies, thanks in part to the strength of the dollar, JPMorgan economists said.

This will not prevent the Fed from tightening the restrictive territory. Anna Wong, chief US economist at Bloomberg Economics, expects the Fed will eventually need to raise rates to 5% to get the US out of the inflation problem.

“Really the problem”

However, the recent decline in several important commodity markets should help lower prices in the global economy:

  • Benchmark crude oil futures have fallen about 20% since early June

  • Prices for metals, lumber and memory chips have all fallen from their highs

  • UN food cost index plunges nearly 9% in July, most since 2008

Much of this appears to be due to a slowdown in demand. That’s partly because consumers are shifting away from unusual shopping habits that emerged during pandemic lockdowns, when people spent less on services like hotel rooms or gym memberships and more on goods like exercise bikes and home computers. Commodity inflation “will come down significantly,” said Jan Hatzius, chief economist at Goldman Sachs Group Inc.

The reversal in commodity prices also reflects the fact that household budgets are increasingly strained – and economies worldwide are slowing.

Most of Europe is expected to fall into recession in the coming months as the energy crisis takes its toll over the winter. China remains hamstrung by its Covid Zero policy and a depressed property market, with commodity price spillovers. In the US, interest rate hikes by the Fed have undermined a once-buoyant housing market and made high-tech companies wary.

Even with recession risks rising, bond investors don’t see central banks easing any time soon. Investors are currently betting that by next March the Fed will have raised rates to around 3.75%, while the ECB’s benchmark will be at 1.75% and the UK’s at 4%.

“Inflation is really the problem, and it remains well above central banks’ targets,” said John Flahive, head of fixed income at BNY Mellon Wealth Management. “They don’t want to make the mistake of cutting rates and watching inflation rise again.”

“I’ve seen the worst”

One sure sign of slowing demand, according to Morgan Stanley economists, is that import growth in major economies – after adjusting for inflation – is already subdued, while exports from Asia, the world’s powerhouses, are beginning to weaken.

Easing logistics congestion also contributes to lower prices. The New York Federal Reserve’s index of global supply chain pressures fell to its lowest level since early 2021. Short-term shipping rates are falling, ocean transit times are shortening and companies are even beginning to bemoan bloated inventories.

“We were getting about 65% service level from our strategic suppliers. That’s back to plus 90 percent now,” Randy Brough, president of Motion Industries Inc., an Alabama-based supplier of industrial components, said at a conference this month. “We really think we’ve seen the worst of the supply chain issues.”

If that’s the case, the Fed may not need to raise rates as much as it fears to curb demand and rein in inflation, according to Apollo Management chief economist Torsten Slok.

Still, even if commodity prices slow, there is a risk that the shift in spending after lockdown could instead push up the prices of services like going to the movies or staying in hotels. They may turn out to be stickier.

US rental costs, in particular, are being driven up by a shortage of affordable housing. That could put pressure on inflation in 2023 and “perhaps even beyond,” says Goldman’s Hatzius.

“Not too far”

Rising wages can also hold down inflation for longer.

Labor costs are the biggest expense for many businesses, especially in service sectors. With labor markets in the US and Europe still tight, companies are being forced to increase pay. In order to maintain their profits, firms will have to pass on their higher wages to consumers.

“We are quite worried about the wage and price spiral,” said Robert Dent, senior US economist at Nomura Securities. “One may already be happening to some degree.”

There is also the argument that inflation will not return to pre-Covid levels because the world is already ready to change. Globalization is unraveling—a process accelerated by the war in Ukraine—and measures to address climate change may add another layer of costs, at least in the short term.

In a report this month, economist Dario Perkins of TS Lombard predicted that such forces would combine to create what he called a “new macro supercycle.”

Central banks “will try to prevent this secular transition, even at the cost of a recession,” but they “cannot stand in the way of structural change,” he wrote. “The persistent era of ‘low inflation’ is over.”

For now, at least, there is a growing consensus that the worst of the current inflationary episode is over for many economies, even if doubts remain about how fast the decline will be and how far it will go.

“Peak inflation is not too far away and should come soon,” said Priyanka Kishore of Oxford Economics. “There may, of course, be deviations. But this is more due to idiosyncratic country factors than global price pressures.” Read more:

  • Pimco is among bondholders calling for an end to the era of low inflation

  • Powell talks tough, says rates likely to stay high for some time

  • Peak US inflation looms, but debate rages over what comes next

  • China plans more fiscal stimulus as economic outlook worsens

  • Energy is rising in Europe as pressure mounts on leaders to ease the pain

  • Rising UK energy bills point to higher inflation and rates

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