Inflation eases – and diverges

  • Inflation in the major economies is now beginning to drop more rapidly.
  • But the twelve-month change is (once again) irrelevant.
  • The Fed will probably hike once or twice more; the ECB will need to do more.

Once again, monetary developments clearly pointed the way. But, of course, this only matters if you actually look at money and try to analyse it, so the signs were wasted on central banks. For those who do think money and monetary trends are important, the collapse of broad money growth in the United States since April last year, and lesser slowdown in the Euro Area since the autumn, were key indicators to falling inflation in 2023. Now we are beginning to see inflation come down, in some cases quite rapidly.

However, what matters now are two things. First, ignore the 12-month rate. That was always bound to fall this spring as the impact of the energy and food price increases in the immediate wake of Russia’s invasion of Ukraine drops out of the comparison. In fact, since at least energy prices fell back quite rapidly after the initial shock, they will give an extra boost downwards to inflation in coming months.

Second, and somewhat counterintuitively in light of the point made above, ignore core inflation. Central banks, in particular but not only the Fed, love to talk about core inflation. But as Dr Dan Thornton, former Vice President of the Federal Reserve Bank of St Louis, has shown, this is really only relevant if core inflation leads the headline – and it doesn’t (see for some of his comments on this topic).

At the moment, the numbers to look at are the three- and six-month annualised changes to inflation. The three-month annualised number is more volatile and can therefore be misleading, but, in general, both are good guides to recent trends.  

While data for both the USA and the EA show inflation coming down, there are clear differences between them. US inflation has been below 5% in a three-month annualised basis since September last year; and on a six-month annualised basis since January this year. On both measures, inflation is currently between 3.5% and 4%. This is of course welcome compared with previous highs of above 10% in the summer of 2022; but it is still not down to the Fed’s 2% target. Fear of something triggering a new bout of inflation, and a desire to ‘normalise’ the policy interest rate will probably make the Fed tighten once or (more likely, but not by any significant margin) twice more, taking the Fed Funds rate to a 5.25-5.5% interval. This will achieve a number of things. It will show that the Fed remains committed to bringing inflation down and keeping it down. It will (helped by falling inflation, of course) mean that the policy rate is positive in real terms. And it will give some scope for cutting interest rates again in late 2023 or early 2024 if deemed necessary. 

Will inflation actually come down to or below 2%? On the one hand, the money numbers remain dire. Broad money (my own replacement for the long since discontinued M3 measure) has been falling on a 12-month basis since October 2022 and on a monthly basis since March last year. The last time we saw similar numbers, in 2010, inflation (after a lag of about one year) dropped below 2% and remained there for most of the next five years. However, demand is likely to be stronger this time around and the labour market remains tight. In addition, the Fed (and the US government!) would probably prefer inflation to remain in the 2.5-3% range, consistent with the Fed’s Average Inflation Targeting policy and with giving the government some relief on its future debt burden.

By contrast, the ECB still has much left to do – not surprising, since it began to tighten policy well after both the Fed and the Bank of England. EA inflation did drop below a three-month annualised rate of 5% last December and actually fell to 1.5% in January. But it has since picked up again and the March number was 6%. Of course, this illustrates the volatility of using three-month annualised numbers; but on the more stable six-month annualised basis, inflation was 5.4% in March. While down from double-digit rates of most of 2022, this is not particularly impressive. Moreover, broad money (M3) growth remains positive on most measures, only going negative on a three-month annualised basis and only since January. The actual level of M3 is only marginally (0.7%) down from a peak in September last year.

Of course, broad money growth does not have to be negative for inflation to come down – it just has to be weak. But broad money growth only dropped below the ECB’s former (long since discarded) 4.5% reference value as recently as last December, meaning that it will most likely take longer for monetary developments to lead to lower inflation. It will also mean more rate hikes from the ECB, whose key policy rate remains negative in real terms. As with the US, it is also questionable whether inflation will eventually fall to the ECB’s 2% target. True, the ECB doesn’t officially practice average inflation target. But enough comments from ECB representatives over the past years have shown that a certain measure of overshoot will be accepted. Moreover, once the benign impact of lower energy and food prices has worked through, it may become more difficult for EA inflation to ease much further in the short run; even more so in the absence of any coordination between fiscal and monetary policy. And there is a further factor: for all that the ECB is supposed to have inherited the Bundesbank’s anti-inflationary bias, in the current cycle, the ECB has if anything shown itself to be much more inflation-friendly than the Fed. Reputations count, for central banks as for anyone else.

Expect, therefore, inflation to continue to come down in the two largest economies; but faster in the USA than in the EA. And interest rates will still have a way to go.

Gabriel Stein