L'AGEFI - Mind the expectations for a slow rate cut cycle

Translation of an article published by L'AGEFI on 4 July 2024
By Michala MARCUSSEN, Group Chief Economist

Inflation has eased substantially on both sides of the Atlantic and is now within reach of target, with the May print for the US at 2.6% YoY (PCE) and the June print for the euro area at 2.5%. This marks a sharp decline from the peak of, respectively, 7.1% (in June 2022) and 10.6% (October 2022).

Both the Fed and the ECB remain cautious, however, in responding with rate cuts, mindful of service price inflation that continues to run above headline inflation and of the risks that a still tight labour market and potential new supply side shocks present, not least in the new more fragmented world order.

A further concern is that nascent fiscal policy tightening may shift quickly back to excessive easing at the first hint of downturn. The final source of significant uncertainty comes from the substantial structural transformations unfolding, be it the green or digital transitions.

Navigating this uncertain environment is no easy task, and it comes as no surprise that central banks have opted for data dependence, further informed by their assessments of the inflation outlook. The question for both the ECB and the Fed is to strike the right balance between the data, much of which is backward looking, and the outlook.

A first point to keep in mind is that data dependence is not data point dependence. ECB President Lagarde made this point in her opening speech at the ECB’s annual forum and it is clear that both the ECB and the Fed will look through some of the inevitable noise present on individual data points. Examples of such temporary noise are in abundance in Europe this summer with the Euro football tournament, Taylor Swift concerts, and the Olympics likely to produce price spikes in tourist related industries, such as accommodation, restaurants and travel prices.

The bigger challenge for the central banks is to understand how much of the apparent stickiness in inflation is a lagged effect from past price shock and how much of this could reignite new inflation. Indeed, when prices higher upstream in the production chain, such as semi-conductor prices, see an increase, this takes time to work its way through the input output structures of the economy to good production and eventually also to services. Several channels are at work in this chain, with each step containing a share, albeit an ever smaller one, of the initial price shock and each step also reflecting the pricing power of both companies and of workers. Indeed, when it comes to services, the wage channel often proves the most important one.

The process of wage negotiations, comes with its own lags and leads. The backward looking element relates to employees seeking to make up for the loss of past purchasing power. The more staggered the wage negotiation process, the longer it takes for this process to play out and for central bankers to gain a fuller picture on the wage dynamics. The forward looking concern relates to the point that higher wages may in return trigger new waves on inflation. Such effects have not been visible to any material extent to date either side of the Atlantic.

Central banks have to manage the risk of a resurgence of inflation against that of tight monetary policy, which comes with its uncertain lags, triggering a more painful economic downturn. Survey data can be particularly helpful to central bankers in guiding this balance, and not least inflation expectations. Indeed, some authors have argued that the error of central banks when price pressures started to build during the pandemic was to respond too slowly to the drift up in medium-term inflation expectations, and not least the tail distribution hereof.

While still tight labour markets may give central banks confidence that they have time on their side when it comes to rate cuts, the picture on inflation expectations should give them confidence that they can safely remove some of the monetary policy restriction. Indeed, one of the most striking features of this cycle is that after one of the fast monetary policy tightening cycles on records, markets are now priced for one of the slowest easing cycles. That, however, may be about to change as labour markets already now show cracks in performance, on both sides of the Atlantic.