Key Takeaways
- Recent US inflation data has disappointed and market expectations for rate cuts have been revised downwards.
- The odds of a June cut in US interest rates are now standing at 50:50. But is pessimism overdone?
- A closer look at the data points to a slowdown in the economy – retail sales are slowing and small businesses a paring back hiring plans.
- With data releases this week, we expect UK inflation to have eased.
- The Federal Reserve will maintain its cautious tone, but we believe the longer-term outlook is positive.
It is a big week for the UK markets with a Bank of England (BoE) meeting and lots of data releases, but it’s events across the Atlantic that are likely to matter most. The US Federal Reserve meets and following some disappointing data on inflation, they may take a cautious line that leads markets to delay and reduce the pace of interest rates cuts that they expect. And that would impact interest rate expectations across the globe. I explain why I think we remain on course for steep cuts in interest rates in the US, UK, and Europe.
Let’s start with that US data. First, consumer price inflation came in above expectations. Only by a smidgeon but that followed a bigger miss the previous month. The real blow came later in the week when producer prices rose significantly and well above expectations. Unlike producer price series in other countries, the US numbers cover the whole economy including services, so they do represent price rises in the pipeline.
As a result, markets reassessed the prospects for US interest rate cuts. The odds on a cut in June, regarded as a certainty at the start of the month became just a little more than 50:50 and the likely total number of cuts this year went from four to three. It’s possible that the Federal Reserve signal this week that they expect only two cuts this year.
My own view is that this pessimism is overdone. Let me explain why. First, slightly stronger US inflation in the early months of this year is not surprising given the strength of the economy at the end of 2023. Real GDP grew by nearly 5% in Q3 and 3.2% in Q4. That’s on a quarter-on-quarter annualised basis by the way and is much stronger than expected. And employment has risen by over one million in the last 5 months.
The US has a highly flexible economy and prices react quickly when demand is strong. But the signs are that the economy is now slowing. Consumers were a powerful factor behind the strong growth last year and some of the special factors behind that strength no longer apply. Firstly, COLAs – cost of living adjustments to social security payments. Last year COLAs were 8.7%, giving a big boost to the incomes of 70 million Americans. It accounted for fully half of the 4.2% rise in total real household incomes. This year’s COLAs will be just 3.2% and real incomes are set to rise by only 2%. Second, US consumers were drawing on their covid piggy banks last year – all that money they received from the government during the pandemic but couldn’t spend due to lockdown. That’s been spent. We can see this effect via the US saving ratio –which measures the proportion of income that isn’t spent. That’s fallen below the pre-covid average. As it edges higher, US consumers will have to slow their spending. Finally, mortgage rates are on the up, reversing much of the decline seen last year. That will slow the housing market, further denting spending.
All this is beginning to show up in the data if you look carefully. Retail sales have slowed. Small business surveys show that hiring plans are being pared back. We expect employment growth to slow significantly in the coming months. All of this will reduce inflation pressures. In addition, wage inflation looks subdued to us, and is already close to the level that would sustain inflation at the Fed’s 2% target.
This week should see the UK report a big fall in inflation. No doubt the BoE will warn of the dangers of cutting interest rates too soon, but I expect UK inflation to hit the 2% target in April and stay there for the rest of the year, even as the economy picks up. The housing market is already recovering with Rightmove prices rising strongly in the latest data.
Over in Europe, the ECB has already guided us to expect a rate cut in June and the economy there is recovering only slowly.
It’s been a difficult couple of weeks as the US Fed takes a cautious line. But the longer-term outlook is distinctly positive in my opinion.
