Key Takeaways
- Central banks are indicating that interest rates will likely stay high for an extended period.
- But with powerful disinflationary forces now at work we could well see price rises ease quicker than many expect.
- Commodity prices are easing, and the wage price spiral is operating in reverse, notably in the US.
- Labour markets are easing as supply increases. People are re-joining the labour force and immigration is bouncing back.
- Against this backdrop we could see US rates cut early in 2024 with the UK following shortly after.
The central banks are telling us to expect interest rates to stay high for an extended period whereas I expect big rate cuts in 2024. The hawkish tone is occurring even as they admit that official rates are near their peak – indeed the US Federal Reserve and the Bank of England both kept rates on hold at their latest meetings. I’ll explain why I’m so much more optimistic on the prospects for interest rates than the central banks or indeed market pricing.
The background to all this is that central banks collectively, were unable to prevent the surge in inflation that followed the end of the Covid pandemic and the invasion of Ukraine. Some may say they were slow to appreciate the scale of the inflationary pressures, believing it would be transitory. The important factor now is for Central Banks to appreciate the power of the disinflationary forces at work and act accordingly.
Commodity prices are the most obvious of these forces. The Bloomberg commodity price index is down by 24% since last June’s peak, having doubled there from the lows in spring 2020. That’s as massive turnaround. Despite the recent rises in oil prices, the index is still falling overall. And although central banks focus on core inflation which excludes food and energy prices, commodities have indirect effects on things like transport and restaurant prices. Given the scale of the turnaround, that matters. Moreover, wage negotiations tend to depend more on headline rather than core inflation and the wage price spiral is now operating in reverse, notably in the US.
The second factor is the labour market. As the pandemic restrictions ended, a severe shortage of labour developed in every developed market country. That led to a surge in nominal wage inflation. But there has been a big adjustment to these unprecedented shortages. Employment is still increasing in the UK, US and much of Europe but the pace is slowing whereas labour supply is increasing as the hangover from the pandemic eases: people are re-joining the labour force and immigration is bouncing back. In the UK, labour supply is rising at 1-1.5% a year, led by non-UK born workers. The increase is even faster in the US. These numbers may seem small, but they are big enough to lead to a significant rise in unemployment which should be evident by year end.
All this is against the welcome background that people still trust central banks to get inflation back to target eventually despite current levels. Inflation expectations are still well anchored which will make the disinflationary process faster and less painful.
I expect the US Federal Reserve to start cutting interest rates early next year, the Bank of England to follow shortly after with the European Central Bank (ECB) joining the party later, though the precise timing will depend on the data. We should see cuts approaching 2% in the UK and US with the ECB rates declining a little less over 2024 overall.
