The global inflationary cycle has peaked. The factors that triggered the initial surge in inflation have been reversed: supply-side factors and previously lax monetary policy.
The question is what follows and indeed whether it will be a similar focus across the globe, or vary by region. The environments that appear most likely to occur are: disinflation characterised by modest growth and low inflation; or stagflation reflected in stagnant growth and low inflation.
While headline rates of inflation are falling globally, uncertainty still exists over core inflation, which is still stubbornly high in some places. This includes the euro area and the UK where second round inflation effects linked to the labour market are in the limelight.
Oil prices have firmed in recent weeks, too, but this seems to reflect recent supply constraints as opposed to resurgent demand, so a sharp rise may be unlikely. Overall, there is still uncertainty in markets as to where inflation may settle, and this may yet mean inflation settling slightly above the widely accepted two per cent target.
There is a shift in the focus of markets, from a focus on inflation to a focus on growth. This has been reflected in the latest volatility seen in US bond yields. A softening in the US labour market may now suggest its Federal Reserve tightening via policy rates is over, although it will still tighten via asset sales as it shrinks its balance sheet.
In turn, this has eased fears of the Fed over-tightening via pushing rates higher and thus the focus in the US has switched, with talk of a soft landing replacing that of a hard landing for the economy. A shift to a focus on growth is also reflected in the renewed attention attached to the sluggish data in China and fears of deflation.
Central bank action
The other theme prominent now is the ongoing process of normalisation of monetary policy. Last week witnessed some notable developments. While global factors and inflation dominated previously, now national and thus diverging trends are evident.
As we anticipated, Brazil cut policy rates. It, like Chile, had been early to tighten as inflation pressures built a few years ago. Emerging economies, often more prudent in their approach to monetary policy before the pandemic and prior to this inflation shock, will now lead the policy easing. With attention switching to a focus on growth, how long will it be before more countries come under pressure to ease?
In contrast, over the last week there was a predictable but unnecessary tightening in policy by the Bank of England, as it raised rates from 5% to 5.25%. The Bank still has a bias to tighten, and one more hike is possible, although with UK inflation set to fall sharply in coming months the final two hikes currently expected by the market may not materialise.
The Bank’s quarterly monetary policy report pointed to a significant rise in unemployment as it views a softer jobs market as necessary to curb inflation. It is likely to retain a bias to hike until it sees either a softer jobs market which curbs wage growth, or core inflation easing.
The economy is fragile and previous monetary tightening is still feeding through, and while talk of a hard landing may have eased in the US it has to remain a risk in the UK if policy tightens further.
The UK, though, should avoid recession as falling inflation limits policy tightening and boosts real incomes and spending.
Notable, too, was the European Central Bank lowering the rate it paid on bank reserves, something we have talked about previously as a likely policy option for the UK. This would save the government money, limiting taxpayers’ funds being transferred via the central bank to commercial banks.
Last week also saw Japanese bonds continue to adjust to the recent tightening by the Bank of Japan as its yield curve control pushed ten-year yields higher. This is another reflection of the current tightening in global liquidity.
So, as we thought might be the case, there has been a shift in the focus of markets from inflation to growth. Next, but not for some time, we expect there to be a shift to a focus on debt. So inflation, to growth, to debt. For now, the issue is whether stagnation or stagflation is more likely, as inflation is expected to decelerate globally.