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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy
Despite a sharp decline in US inflation over the past year, the monthly US data release on movement in prices continues to garner significant attention, extending beyond economists and market participants. It shapes perspectives on economic growth prospects, central bank policy and market performance. It also has social and political consequences.
And now the data has sent a warning shot. Last week’s release showed that on an annual basis, headline inflation increased from 3.1 per cent to 3.4 per cent, surpassing the consensus forecast of 3.2 per cent.
After that rate had hit a peak of 9 per cent in 2022, the US economy has led to a generalised fall in consumer price inflation across the advanced world. Surprisingly, this impressive disinflation has not impeded growth or employment. The US economy has continued to outperform internationally, growing almost 5 per cent in the third quarter of 2023 and, according to consensus forecasts, above 2 per cent in the final quarter of the year. Meanwhile, unemployment has remained at a low 3.7 per cent, with impressive monthly job creation and low weekly jobless claims.
This unique combination anchors consensus expectations of a very soft landing for the economy. It is the primary reason why markets are pricing in rate cuts (starting in March) double the 0.75 percentage points signalled by Federal Reserve officials, and analysts forecast that markets will build on last year’s impressive rally.
It has offered hope to the Biden administration that voters will put behind them the unanticipated inflation shock and, instead, focus more on the recent real wage gains, robust job creation and legislative measures supporting future growth and productivity.
However, caution was already warranted in the “last mile” of the inflation battle before last Thursday’s data release. There are even more reasons now given the numbers and the most recent geopolitical developments.
Going into the release, reaching the Fed’s 2 per cent inflation target quickly required accelerated disinflation in the services sector to accompany the persistent slowing of price growth (and in some cases outright deflation) for goods. The task was to be made more difficult due to less favourable year-on-year comparisons, so-called base effects.
Thursday’s data highlighted the degree of difficulty. While core inflation edged lower from 4.0 per cent to 3.9 per cent in the month, this was higher than consensus market forecasts of 3.8 per cent. Meanwhile, the data is yet to reflect cost pressures already in the pipeline. The current disruption to Red Sea navigation will impact inflation directly, by increasing input and final goods prices, and indirectly, by delaying the availability of goods. The economy will also need to absorb higher labour costs.
The implications for growth depend largely on whether the Fed is willing to tolerate a longer period of inflation above its 2 per cent target. There is little risk to economic and financial stability in running an implicit inflation target closer to 3 per cent for now. Indeed, it is warranted, given the current global period of less flexible aggregate supply — a multiyear environment that is opposite to the world of insufficient aggregate demand that dominated the decade after the 2008 financial crisis.
Politically, the Biden administration cannot simply rely on lower inflation to alleviate voters’ concerns about its economic management. It needs to communicate more effectively the exceptionalism of US economic performance relative to other advanced economies, as well as translate into more accessible language how its policy approach promotes more inclusive and sustainable growth in the future.
Finally, financial markets need to recognise that the Fed’s guidance of 0.75 percentage points of rate cuts starting later in the year is more reasonable than the significantly more dovish current market pricing. In terms of strategy for investors, this translates into a greater focus on individual name selection in investments (as opposed to passive index investing), sound structuring and solid balance sheets.
Returning quickly to 2 per cent was never going to be easy for the US economy, especially considering the Fed’s initial mistakes of analysis and policy reaction. The recent data serves as a surprisingly early warning of the long and winding road ahead in the last mile of the inflation battle. What would make things a lot more reassuring this year — for the economy, the markets and the Biden administration — is a set of domestic and international measures that promote the supply flexibility that enables the “immaculate inflation” that many have been hoping for.
