Key Takeaways
- Inflation has fallen in all the major economies and central banks have been able to keep policy on hold.
- But core inflation remains well above 2% targets and there’s uncertainty around whether downward trends will continue.
- The UK has lagged other countries in terms of falling inflation, but we expect the gap to narrow significantly in upcoming data.
- Unemployment looks set to rise in the months ahead – we believe the Sahm rule could be triggered in early 2024 in the US.
- Easing wage inflation bodes well for core inflation in the UK and unemployment in Europe will likely rise from here.
- The path to lower interest rates from key central banks seems clearer and this will be good news for bonds and equities.
Inflation has fallen in all major countries from the heady levels seen in the spring. Core inflation has also eased and all this has occurred without recession. As a result, the major central banks have kept policy on hold, bringing an end, or at least a pause, to their aggressive rate-rising strategy. That’s the good news. The problem facing central banks is that core inflation remains well above the various 2% targets and they are unsure whether the recent downward trends in inflation will continue. Their dilemma is considerably eased by continued tight labour markets: unemployment is generally at or close to record lows.
The UK has been a distinct laggard in the disinflation race. The gap should narrow significantly this week with UK headline inflation expected to fall by 2% from 6.7% to 4.7%. Core inflation should also fall but to something like 5.8%, way above the Bank of England’s (BoE) target. Against this background the only sensible choice for the BoE is either to increase rates or to keep them on hold. And this was reflected in the voting at their last meeting with 6 members voting to keep rates on hold, the other 3 voting for a further increase. To a greater or lesser extent, most other central banks are in the same position.
So what might change? We expect rising unemployment to be a feature over the winter. The latest figures show US unemployment having risen to 3.9% compared with a trough of 3.4% in April. That is still low but were that half a percentage point increase to be realised on a 3-month moving average basis, it would trigger the Sahm rule, which has accurately called the timing of previous US recessions, outperforming the more familiar yield curve rule. Employment is still growing in the US but labour supply, led by immigration, is increasing faster. I expect the Sahm rule to be triggered early in 2024.
There is no equivalent to the Sahm rule in Europe. Indeed, in the Eurozone, unemployment is at a record low. But given stagnant growth, an increase over the winter looks highly likely. That should be accompanied by much lower core inflation: JP Morgan estimate that the 3 month annualised rate will fall to just 2.4% by year end.
In the UK, measuring wages and unemployment is tricky given that the key data sources in this area have been abandoned by the Office for National Statistics (ONS) due to a low response rate in the survey. Fortunately, the ONS has alternative sources which are potentially much better in my view. These show a major decline in wage inflation. If as seems likely this translates into further progress on core inflation, the BoE will begin seriously to consider interest rate cuts. That would be a big change.
All in all, we expect significant cuts in interest rates from the leading central banks in 2024. Progress will not be smooth. Indeed, this week’s US inflation data may suggest that the decline in core inflation there has stalled. But the trend is clear in our view. The war against inflation is not yet won but the tide has turned. If I’m right that will be good news for bonds and equities alike.
