Trouble in the Tetons… Disinflation and the global outlook

Central bankers are keenly aware of something many economists overlook. Most consumers are frustrated with the level of prices, which are still well above pre-pandemic norms, not just the pace at which those prices are rising. If the goal is to remove the distortions due to the inflation triggered by the pandemic, then we need to both lower the pace of inflation and allow for a period of catch up in inflation-adjusted wages.

The good news is that many of the supply chain disruptions that plagued reopening and pushed goods prices higher have abated. Rate hikes have also dampened demand, especially for housing and vehicles, which require financing.

Shelter costs have begun to cool and are poised to further ease in the latter half of the year. Rents have rolled over and it is only a matter of time before those shifts work their way through to new leases.

The sticking point for the U.S. and Canada is that acute shortages of single-family homes for sale have buoyed home values and triggered bidding wars on the few homes that do hit the market. A similar phenomenon has occured in the U.K. That poses the risk of a rebound in shelter costs down the road.

Service sector prices have cooled but not enough to ensure a persistent cooling of overall inflation. That is where the focus on the labor market comes into play.

Chart 1 shows the progress in inflation across the major developed economies over the last year. We have come a long way from the peak in mid-2022. The U.S. has made more progress than most other major developed countries, but inflation “remains too high.”

Chart 2 shows the core PCE (excluding food and energy) measure of inflation for the U.S., which is the Fed’s preferred measure, as it best predicts future inflation. It has come down from its peak, but unevenly.

In July, the core PCE rose 0.2% from June. That translated to a 4.2% increase from a year ago, slightly above the 4.1% pace of June. The three-month moving average, which better measures the momentum, slipped to 2.9% in July. That is the lowest reading on core inflation since January 2021 but still a long way from 2%.

Therein lies the rub. The only way to get the core PCE measure of inflation close to 2% by year-end is if prices do not move at all between now and then. The only time we have seen anything resembling that was when the credit markets seized in the wake of Lehman’s failure in 2008. Employment imploded, unemployment soared, credit lines evaporated and the economy slipped into the deepest recession since the Great Depression; deflation was a palpable threat.

The trajectory of core services inflation, which strips out shelter and energy services, is even more worrisome. It accelerated in July. The core services index jumped 0.5% from June and 4.7% from a year ago. That is the fastest monthly pace since January and the largest annual jump since February. The three-month moving average came in at 3.9%, the hottest pace since April.

A surge in portfolio management services, which were fueled by a strong stock market, accounted for 0.2% of that 0.5% increase. Let’s assume that abates and core services don’t move in price between now and the end of the year, another highly unlikely scenario. Even then, inflation would end the year closer to 3% than 2%.

Now add the reality that services are much more labor-intensive than goods. That makes them more sensitive to wage growth and less responsive to rate hikes. Wages have cooled from the red-hot pace we saw in mid-2022 but remain well above the level consistent with the Fed’s 2% inflation target. Average hourly earnings rose 4.3% from a year ago in August, a tick down from the 4.4% pace of July, but still a full percentage point above the pace of 2019.

Chart 3 shows the forecast for global growth by the International Monetary Fund (IMF). Growth is expected to slow from 3.5% in 2022 to 3% in 2023 and 2024. That is a marked slowdown from the subdued pace of the 2010s.

That said, the forecast is getting murkier. Some economies, such as the U.S., Mexico and Brazil are surprising to the upside, while growth in Asia is surprising to the downside. Contagion from the slowdown in manufacturing activity in China is showing up as weaker growth in Korea, Taiwan and Japan.

The eurozone has slipped into a technical recession, led by Germany. The U.K. is struggling along with emerging markets outside of India. Türkiye’s new finance minister is making progress, but concern about a banking crisis there remains elevated.

Debt restructuring across emerging markets has picked up and is staving off larger crises. China is playing a role in that restructuring with negotiations on loans for its Belt and Road project. That said, mounting sovereign debt, and the rise in the costs of servicing that debt was a concern throughout the conference.

One entire session was devoted to it. The consensus was that there was no easy fix to our collective debt problems; they are likely to get worse in coming years. The U.S. was considered a leading offender.

The increased demands created by escalating geopolitical tensions, the war in Ukraine and climate change posed new challenges. All required more instead of less government spending, with little desire to raise the tax revenues needed to pay for that spending. Deepening political divisions are exacerbating those fiscal tensions.

That left little wiggle room to deal with our next major emergency, or the problem staring at us in the mirror - the economics of dealing with an ageing population. Everything from the costs of retirement to medical care was expected to accelerate, as a larger part of our collective populations left the work force.

A related concern was the functioning of the U.S. Treasury bond market, which is a crucial aspect of the plumbing of the global economy. Liquidity in the U.S. Treasury market has never returned to pre-pandemic levels. Those shifts, coupled with the need to issue more debt, have pushed bond yields higher.

Reductions in the Fed’s bloated balance sheet and a shift in the buyers of Treasury bonds have intensified  volatility in the bond market. Private investors now overshadow foreign governments and are more susceptible to external shocks, like the recent downgrade of U.S. debt by Fitch Ratings.

That said, efforts to pivot away from the U.S. dollar as a reserve currency are expected to fail. The Chinese renminbi has replaced the yen and the euro across many emerging markets. Much of that is due to a surge in purchases by Russia and Brazil; the holdings of the now-depreciating renminbi is destabilizing for foreign balance sheets. The dollar is still a safe haven because there are no alternatives.

The push to hedge supply chains with just-in-case instead of just-in-time inventory systems has abated. The costs are simply too high in a world where the fees for insurance and financing inventories have both risen.

More regionalizing and friend-shoring is occurring than onshoring. Producers are shifting away from China to Vietnam, Malaysia, the Philippines and Mexico. Simultaneously, China has increased trade with those same countries, which indirectly preserves the trade links with China. (This enables Chinese companies to avoid some tariffs.)

Mexico is the largest winner, given its proximity to the U.S. and Canada, and the guarantees in the USMCA trade agreement. The low-hanging fruit of globalization, which pushed inflation down for decades, has been plucked.

Brexit provided a case study. The U.K. is now suffering the stickiest inflation among the developed economies. Much of that can be traced to Brexit, which closed borders, boosted tariffs and is now losing its appeal with voters.

Climate change and the need to pivot for both security and environmental reasons to renewables was discussed. The frequency and ferocity of extreme weather events is poised to accelerate, even if the carbon neutral goals of the Paris Accord could be reached. That means more supply chain disruptions.

The Panama Canal, its low tides and the backlogs it has triggered is a case in point. As of the writing of this report there was a 15-day backlog of ships waiting to dock off the shores of the Port of Houston Bayport Terminal, which is responsible for oil and gas shipments.

This is in addition to El Niño, a twice in a decade event. That could jeopardize crops and livestock and push up the costs of fertilizers and commodities the world over. A cold snap, which is now more likely this winter, from Europe to the U.S., could increase the demand for energy and cause another round of energy shortages and related price hikes.

Lagarde also noted the investment boom triggered by the push to adopt renewables, also known as “greenflation.” That is in addition to government deficits and increasing pressure on inflation created by the countercyclical ramp up in government spending associated with escalating geopolitical tensions.