Inflation - down, not out

11 December 2023

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.

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index closed the week up 0.3% at 7,554.

Economics

Credit rating agency Moody’s cut China’s outlook to ‘negative’ citing persistently lower growth and the property sector crisis as key downside risks
China president Xi Jinping warned that China’s economic recovery was “still at a critical stage” as he pledged to support growth with further “proactive” fiscal and “effective” monetary policy
The price of Brent crude oil fell below $75 a barrel, for the first time since June despite the announcement of additional OPEC+ cuts due to weak global demand and rising US production
US job growth was more robust than previously anticipated in November as unemployment fell to 3.7%, paring back some of the bets on early interest rate cuts
Corporate bond issuances saw a 57% monthly uptick in November as investors rushed to riskier assets as they price in lower interest rates in advanced economies
UK economic activity expanded marginally in November as the composite purchasing managers’ index rose to 50.7, service activity expanded faster than anticipated and manufacturing’s slump eased. However, construction activity contracted for a third consecutive month due to a weak housing market
UK ten-year gilt yields fell below 4% for the first time since May as markets expect three to four interest rate cuts by the Bank of England next year
UK household inflation expectations for the next 12 months fell to 3.3% in November, the lowest figure since November 2021, according to the Bank of England
Inflation hit UK households with mortgages the hardest due to rising interest rate payments, according to the Office for National Statistics
UK house prices recovered again in November, according to the Halifax house price index which showed a 0.5% monthly increase, but experts warn that seasonality may be the reason behind the positive numbers
UK developer Berkeley Group said that build costs may have peaked as energy prices and demand fell
Germany’s industrial orders fell 3.7% in October and manufacturing activity contracted for a fifth consecutive month as the country’s industrial slump continues
German companies cut back on investment plans in 2023 due to “increased financing costs, weak demand and economic policy uncertainty”, according to the Ifo Institute
Inflation in OECD economies fell to 5.6% in September, the lowest level in two years, with 32 out of the 38 member countries registering declines in food inflation
Ireland’s corporation tax receipts rebounded in November after falling for three months in a row, alleviating fears that the inflow from international tech and pharma companies had peaked
Chinese exports unexpectedly rose slightly in November, the first time in six months as companies reduced their prices in lieu of strong global demand

Business

Music streaming platform Spotify set out plans to cut 17% of its global workforce due to higher financing costs and slowing demand
US energy company ExxonMobil announced plans to increase oil and gas production by 10% by 2027 as the company bets on higher oil prices in years to come
The Bank of England warned of potential “sharp revaluations” in private non-bank credit due to a worsening of the macroeconomic outlook
Tech entrepreneur Elon Musk’s artificial intelligence start-up xAI is looking to raise $1bn in equity as investors seek to commercialise the new technology
The European Union proposed a three-year delay for the introduction of a 10% tariff on UK electric vehicles
Jewellery retailer Signet Jewelers said that consumers in advanced economies are more likely to wait for discounts during the holiday season as they scale back discretionary spending on luxury goods
US bank Wells Fargo announced that it set aside $1bn for ‘unanticipated’ severance packages as it looks to scale back its headcount
The number of mergers and acquisitions involving UK companies fell in the third quarter to the lowest levels since the start of the pandemic, according to the Office for National Statistics
Credit rating agency Moody’s issued a ‘negative’ outlook for the global banking sector in 2024 due to a “deteriorating” environment as the number of bad loans rises
Telecommunication group Telefónica revealed plans to cut almost a quarter of its workforce in Spain as part of a process of transformation
US high-end furniture retailer RH blamed high mortgage costs for an unexpected loss in the third quarter as the “frozen” US housing market cut demand for furniture

Global and political developments

UK prime minister Rishi Sunak announced a further tightening of the country’s immigration policy through emergency legislation, amid backlash from the right of the Conservative Party and after the resignation of immigration minister Robert Jenrick
G7 nations agreed to ban diamond imports from Russia as one of the few remaining major Russian exports not yet targeted by western sanctions. However, scepticism is growing on the efficacy of such bans as trade routes through countries like Kyrgyzstan seem to be used to bypass sanctions
Italy announced it withdrew from the China-led Belt & Road Initiative after a warning from western nations that the scheme is an example of "debt-trap diplomacy"
Guyana’s vice president Bharrat Jagdeo said the country must be prepared for the worst, following Venezuela’s decision to claim the oil-and-mineral-rich region Guayana Esequiba

And finally… a group of tourists had an interesting trip to Venice. While taking the customary gondola ride through the river and canals of Venice, the visitors fell into the water when they capsized the vessel trying to take selfies – A-river-derci

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