A string of data from the US suggests that inflation may be heading down towards the Federal Reserve’s 2% target without the need for a recession. That’s what we mean by a soft landing. The pattern so far has been for measures of consumer price inflation (CPI) to fall significantly and by more than expected. The latest CPI figures show that inflation fell to just 3% in June. Wage inflation has also slowed according to key data released last week and there is a real possibility of a wage price spiral operating in reverse. All of this has occurred with unemployment remaining very low. A US soft landing is by no means certain but it’s an outcome that now looks like becoming the consensus. This is a big change, good news for risk assets in the US and beyond.
It also raises the questions of whether the UK & Europe can emulate the success of the US. We think this is a distinct possibility, but it will take time and a difficult period lies ahead.
Let’s start with the Eurozone. Recent economic data have been dreadful with numbers coming in weak – and weaker than expected. The closely watched Purchasing Managers Indices have dipped into negative territory. Bank lending surveys show credit conditions have tightened and demand for credit has slumped. Things may not be quite as bad as the headlines suggest. There is a north south divide: German retail sales volumes have been weak, with year over year growth only just turning positive but Spain has been enjoying a consumer boom. There’s a sectoral divide too: manufacturing is weak, services strong, a phenomenon that’s evident almost everywhere. We get much more data on Germany and manufacturing so the picture gets distorted: things are not as bad as the headlines suggest. And unemployment is still falling – it’s now at record lows for the eurozone.
There has been a significant improvement in consumer confidence, and unspent savings mean that this can translate into more spending. But inflation is still high, double that in the US and that means upward pressure on wages. Europe may have less indexation that in the past but it still has much more than in the US so the wage price spiral is still going the wrong way. Relief will come as headline inflation drops but it will be several months before we get much of a further decline.
The UK has its own special factors. The structure of the UK housing market makes our economy more vulnerable to the rise in official interest rates than the Eurozone or the US. The recent 10% rise in UK minimum wages is welcome from a social perspective but it has boosted wage inflation. That’s a one off and will not be repeated next year. Last year’s sterling weakness is adding as much as 2 percentage points to current inflation: that is set to fade and then reverse in response to recent sterling strength. The last set of inflation data have shown a marked improvement and will improve further as household energy bills (up by 200% in the latest figures, drop by 17% next month and fall further in October).
But as with Europe, the starting point for inflation is higher and the path to a soft landing more uncertain.
The good news is that financial markets have given Europe and the UK the benefit of the doubt having seen the soft landing in the US. And that’s the view I share.
