Key Takeaways
- Markets have revised expectations for interest rate cuts downwards in recent months.
- Recent US data suggests that inflation is no longer falling – we think that the weightings of rents in inflation indices are skewing the numbers.
- US wage inflation is falling, and we think that might allow the Federal Reserve to move quicker than markets now expect.
- Europe’s central bankers have signalled a 0.25% in June and we think that will go ahead.
- The outlook is cloudier in the UK, but wage inflation is easing and there is growing consensus that inflation is about to hit the 2% target.
Optimism about the scale and timing of interest rate cuts in the major economies has declined consistently in recent months. The year began with markets pricing cuts by June of 60 bps or so in the US, UK, and Eurozone. Those numbers are now down to 6, 12 and 22 bps respectively.
So what is the outlook for interest rates now? Let’s start with the US, where the shift in interest rate expectations has been greatest. That move reflects data suggesting that inflation is no longer falling and remains above target. As discussed in recent updates, this largely reflects inflation in rents (or shelter as they call it) which is stuck at close to 6%. This effect is magnified by the high weight placed on shelter in the US CPI. It’s 36%, so far higher than in other countries. The weight of actual rents is at 8% so not significantly different from elsewhere but the US add something called Owners Equivalent Rent. That’s what homeowners would pay if they rented their house from themselves. Sounds crazy? I agree. Exclude shelter and CPI inflation has been at or around 2% in the US for the last 12 months. If rental inflation were to remain at 6%, the rest of the CPI would have to show zero inflation to get the total to 2%.
The Fed actually target something call the personal consumers expenditure deflator. That has a lower weight on shelter but at 18% it still seems too high.
So where are we left? The Federal Reserve (Fed) won’t be adjusting their targets to downgrade shelter any time soon. However, there is cause for optimism. Ultimately rents and the cost of other services are determined by wages with a bit knocked off for productivity. And wage inflation is falling. There are many measures of wages in the US but they show a consistent pattern. The gold standard is the employment cost index which comes out quarterly. This series has been slowing since it peaked at 5% year-on-year last June and I expect it be 3 point something and heading to a rate consistent with the Fed’s 2% target when the next number is released at the end of this month. It’s a close call but I reckon this will mean US will go ahead and cut rates by ¼ of 1 percent in June.
Over in Europe, we can be more confident of a ¼ point rate cut in June. Not just because the fundamentals justify it but because the members of the European Central Bank (ECB) have told us that they will cut. Or as close to that as central bankers ever come!
It’s a bit cloudier here in the UK but the growing consensus that our inflation is about to hit the 2% target and stay there for the next 12 months means that the Bank of England are likely to match the ECB’s rate cut. Wage inflation is falling here too, though from a higher level than in the US and we have yet to see the full effects of this month’s 10% rise in the minimum wage.
So, I think market pessimism over cuts is overdone. If I’m right, we are in for favourable surprises in the next few months which would be a positive background for financial markets.
