Inflation - down, not out - The Monday Briefing

Shorter  milder UK recession in prospect

Inflation is in retreat across the western world. The biggest inflation shock in decades is unwinding as growth slows. In the euro area inflation has dropped from a peak of 10.6% to 2.4% in the space of a year. America’s inflation rate has fallen from over 9.0% to 3.2%. Inflation has been stickier in the UK but has fallen from 11.1% to 4.6%. October saw the largest one-month decline in the UK inflation rate in over 30 years.

A period of soaring commodity prices and supply shortages seems to be drawing to a close.  European gas prices are trading at about 13% of their August 2022 peak. Despite the best efforts of OPEC to prop up prices by restricting supply, the price of Brent crude has dropped from a peak of $122 a barrel to $76 on Friday. Most metal and agricultural prices are off their highs. (A striking exception is gold that has reached an all-time high on geopolitical tensions and a growing view that interest rates have peaked.)

Consumers are benefitting as lower commodity prices feed through the system. In the US goods price inflation is flat. 18 months ago, it was rising by over 12%. In the UK the soaring costs of bicycles and second-hand cars were just one economic manifestation of the pandemic. Today bicycle and second-hand car prices are falling.

Financial markets seem increasingly confident that inflation is beaten. Market expectations for inflation have fallen and investors are increasingly focussed on when central banks will cut interest rates. The recent decline in mortgage rates in the US and UK is a product of this reassessment.  

This is all good news. But it would be premature to think that our inflation problems are entirely over.

First, rates of inflation are falling, but prices are much higher than they were three years ago and are still rising. In the UK the prices are 21% higher than in December 2020, and are rising by 4.6% year on year. Food prices are a particular problem. In the UK food prices are 30% higher than three years ago and are rising at an annual rate of 11.0%. Agreed, growth in earnings is outstripping inflation again, but for most wage earners spending power is lower than it was three years ago.  

Second, inflation is certainly down, but it is not out. In the euro area, the US and the UK inflation is still above its 2.0% target. Most of the fall in inflation has been driven by sharp declines in the price of goods. Service inflation, which is more heavily influenced by wage costs, remains at high levels. Anyone who’s recently paid for car repairs in the UK (up 8.7% in the last year), package holidays (up 11.2%) or car insurance (up an amazing 47.7%) has experienced this. Central banks worry that inflation, which was initially driven by supply shortages and commodity prices, may have become embedded in the system through wage and price-setting behaviour.

There is a more fundamental issue. Unemployment in Europe and North America is at low levels. Measures of capacity utilisation – which gauge the extent to which plant, machinery, factories and services are being used – are down only modestly from their peaks. The corollary of having avoided recessions, is that central banks having not freed up much spare capacity. Long periods of low inflation tend to start with economies sitting on large amounts of free capacity. That is not the situation today.  

Big falls in headline inflation this year suggest that the worst of the inflation shock is behind us. But I doubt that there’ll be much popping of champagne corks this Christmas in the Bank of England, the Federal Reserve or the ECB. For that they’d want evidence that underlying inflation, especially wage pressures, is back to normal. Maybe next year.