Is business prescient? Or deluded?

  • US inflation eased slightly in July, but at 8.5%, remains high.
  • EA inflation accelerated to reach 9.1% in August.
  • But business surveys show inflation perceptions falling. Prescience? Or delusion?

World inflation remains elevated. Although the US CPI was unchanged on a monthly basis in July, the twelve-month change still racked up 8.5%. This makes it the fifth consecutive month of above-8% inflation and the 16th consecutive month of inflation above 3%. PCE inflation (the Fed’s target) is lower at 6.3% in the year to July. But while down from 6.8% in June, is remains considerably higher than anything seen since the late 1980s.

In the euro area, meanwhile, inflation continued to accelerate, with the headline rate at 9.1% in August and the core rate at 4.2%, again multi-decade highs.

The Federal Reserve has at least gone some way in raising interest rates; the ECB only began to tighten in July.

In the light of these developments, recent business survey data is very interesting. 

In the US, the ISM (manufacturing) survey’s prices paid index fell for a fifth consecutive month in August. This index peaked at 92.1 in June 2021; it then drifted erratically down to 68.2 in December last year, before rising back to 87.1 in February. But in August, it was down to 52.5. That is actually lower than its long-term (post-1948) average of 62.3, and fairly similar to readings of the pre-pandemic 2010s, when inflation was too low, rather than too high.

EA business surveys show a similar trend, although by no means as pronounced. The selling-price expectations in manufacturing index (selling price over the next three months) peaked at 59 in April this year and has since dropped to 44 in August, the lowest reading since October 2021. This is still very high by historic standards: the long-term (post-1985) average is 8 and the index reading consistent with inflation at 2% is traditionally around 10.

Nevertheless, in both the US and in the euro area business seems to be sending signals that inflation has peaked. Both surveys have a reasonable, although by no means perfect relationship with eventual inflation. The question now becomes, is business prescient? Or deluded?

It is still early days. However, there are two arguments in favour of the peak inflation view. The first is the sharp slowdown in broad money growth. This actually began back in 2021, but it has accelerated this year. In the US, broad money (my own recreation of M3) grew by 4.5% in the year to July and the stock of money actually fell on a monthly basis in both June and July. EA broad money growth has slowed by less, but was 5.5% in the year to July, a two-and-a-half year low. More importantly, broad money growth in both economies is well within ranges historically consistent with inflation at or around target.

The second argument is perhaps more surprising, but nevertheless valid. Much of current inflation is of course due to higher food and energy prices brought on by the Russian invasion of Ukraine. But, crucially, in order for inflation to continue to accelerate, these prices have to keep rising. If they don’t, inflation will stabilise. True, the overall price level will be higher than in in 2019 – but it shouldn’t rise by more, or at least not by as much more as recently (subject to second-round effects, of course).

A potential third explanation is that businesses believe that central banks will be able to control inflation and bring it down to or at least near target. But that would not explain why price expectations/prices paid began to ease four or five months ago.

The alternative is that businesses are being deluded. For whatever reason, they believe that inflation is coming down, while in fact, it is still accelerating. If this explanation holds true, we should soon see both surveys start to move in the opposite direction again. 

On balance, the arguments that inflation will ease, probably from late 2022 on and into 2023 seems more plausible, particularly against the monetary background. But it could go either way. At least, we will know soon enough. But regardless of which turns out to be true, central banks will keep raising interest rates.