MIKE DOLAN: Disinflation creates a policy dilemma

If ebbing inflation starts to rekindle household confidence, even in the face of higher interest rates, the central bank policy horizon may be hazier than markets have so far assumed.

For many investors the playbook has been that steep interest rate rises to rein in post-pandemic inflation would slow demand, hit corporate margins and jobs and tip economies into recession.

That would then allow quick monetary easing as annual price rises subside to target. But while economies have slowed and corporate earnings growth has stalled under the weight of tighter credit, employment has held firm and now there are some signs that sharp disinflation itself may prop up household demand too.

While it is only one survey, the University of Michigan’s monthly consumer survey for June shows confidence building again as public inflation expectations dissipate, even before the Federal Reserve has finished its rate rise campaign.

After a week that showed US headline annual inflation falling to 4% in May for the first time in more than two years, the University of Michigan’s survey shows one-year inflation expectations down 1.2 points to just 3.3%, the biggest monthly drop since 2008.

Related consumer confidence soundings on both current conditions and expectations jumped. The resilience of the US labour market, with unemployment still below 4%, is clearly the critical factor.

With annual hourly wage growth of 4.3% now positive again in real, inflation-adjusted, terms for the first time since March 2021, it’s not hard to see what’s lifting the gloom.

All the usual caveats apply, of course. Can that real wage growth persist if the jobs market now loosens with a lag from the swingeing five percentage points of rate hikes in just 15 months? And will top-line inflation fall much further if year-on-year energy price deflation flattens out while "core” price rises remain sticky?

What’s more, other surveys have yet to show inflation expectations falling so sharply or lifting confidence. Though it has yet to report June readings, the Conference Board’s household poll in May still had a one-year ahead inflation view almost twice that of the Michigan survey and confidence readings at their low for the year.

Some experts dismiss public surveys as an inaccurate predictor of inflation anyway, even if they do reflect sentiment. But if falling inflation and inflation expectations are lifting confidence and demand again while jobs remain plentiful, then it both underlines the economic "soft landing” thesis and at least questions a narrative on interest rate reversals.

Muddier view

The "peak and reverse” assumption on Fed rates that herded so many into bonds rather than equities at the start of the year is under pressure, with futures markets now assuming policy rates end 2023 at 5.25% — roughly where they the are right now and a full point above where they were just six weeks ago.

They don’t assume a return below 5% until at least next March. Fed tightening may well be near over, but it’s a muddier view on what happens after.

The June global fund manager survey from Bank of America last week shows investors registering their most overweight position in bonds in eight years. While almost all asset managers think inflation will be lower over the coming year, they remain underweight equity as a net 62% of respondents see a weaker economy in this period. Even though most think it will be some sort of "soft landing”, only 14% saw no recession over 18 months.

The possibility of a disinflation spur to demand at this juncture may complicate that picture considerably.

The story in Europe is different — not least in Britain, where inflation has been much slower to fall this year and markets now see another 130 basis points of Bank of England hikes to 5.8%. Crucially, they see rates remaining more than a point higher than they are now in more than a year’s time.

Importantly, the slower fall in inflation in both Britain and the eurozone means real wage growth remains negative — unlike the latest twist stateside. But the final quarters of 2023 may see that emerge there too.

UBS Global Wealth Management describes the US puzzle in the second half as a "balancing act” for investors, with only a narrow path higher for stocks and quality bonds preferable.

Yet Goldman Sachs economists reckon US inflation is set to "slow meaningfully” again in the second half, with the core PCE measure that is watched closely by the Fed dropping another point to 3.7% by December.

"As long as growth holds too, this should continue to squeeze out lingering recession risk fears and should continue the support for equities and carry,” macro adviser Dom Wilson told clients.

Reuters