Next week markets will receive January Consumer Price Index (CPI) inflation prints from the US and the UK, which will no doubt be widely followed. In the US, the Bloomberg consensus is for a significant drop in headline CPI from 3.4% to 2.9%, while core is expected to decline by a less spectacular 20 bps from 3.9% to 3.7%. For the UK, consensus is for a small increase in CPI inflation from 4.0% to 4.1%. This would be in line with last week’s BoE’s monetary policy report forecasts. For core inflation, the expectation is for a small decline from 5.1% to 5.0%.
It’s important to keep in mind that both countries showed December CPI prints that were above market expectations, which highlights that the road towards target is unlikely to be a straight line (as we argued in this blog ). Markets, and certainly the Fed and the BoE, don’t need another surprise next week.
While the situation in the US and the UK regarding inflation is not exactly the same, we think part of central bankers’ attention on both sides of the pond will be on the interaction between goods and services inflation trends. To be clear, policy targets are at the aggregated level so that’s the most important variable to look at. But dynamics in these two sectors have diverged post pandemic.
As supply chains have largely normalised, goods inflation has declined markedly since the second half of 2022. In the US, goods inflation has hovered around the zero mark for the best part of the last six months. In the UK, goods prices began falling in earnest a few months after they did in the US. The figure currently sits at 1.9% and the trend is likely to continue moving lower but maybe not as quickly. We note that energy deflation (currently running at -17.3%) is set to trend higher (i.e. closer to zero) in coming months as base effects start playing a role. This is evidence that CPI inflation figures have been reaping the rewards of supply chains normalising, but this cannot continue forever and might already be showing signs of exhaustion.
Services inflation has also moved in the right direction from its peaks. Not surprisingly, these peaks occurred after those in goods inflation. In the US, services inflation reached a high of close to 7.5% in February 2023 and now stands at 4.9%. In the UK, services inflation also reached 7.5% last July and has now fallen to 6.4%. As an aside, in the UK there was quite a steep fall in services inflation in January 2023 from December 2022. Therefore, it is likely that next week’s year-on-year measure of services inflation is higher than in the previous month. It is probably better to focus on the month-on-month measure because of this. In any case, these services inflation levels in the US and the UK are still too high and if goods disinflation becomes less of a driving force going forward, then services inflation needs to keep declining for the headline to move towards target. Because the services sector tends to be labour intensive, wages data is at the centre of how quickly services inflation can decline in coming months. This is one of the main factors that brings about some uncertainty as to how easy or not the “last mile” will be in the journey towards central banks inflation targets.
We do believe that the trend in inflation is encouraging, and we do not see at this stage evidence that we are about to experience another bout of sustained inflation. The shock post pandemic was comprised of both a supply and a demand component. The supply side of the equation has largely been amended as most supply chain indicators are back to normal, which has had a marked impact in goods disinflation.
On the demand side, fiscal policy played a huge role in providing consumers with excess savings that were subsequently chasing a reduced supply of goods and services, thereby pushing up prices. At the same time interest rates were at rock bottom levels through quantitative easing and expansive monetary policy. Both are in a very different position now. Fiscal policy is far from neutral with deficits still at elevated levels. But the budget deficits are half of what they were in 2020 and consumers have at least used part of their excess savings. Regarding monetary policy, rates are in restrictive territory and there are quantitative tightening programmes in place targeted at withdrawing stimulus from the economy.
In summary, we need to see services inflation continuing its downward trend as goods disinflation might be running out of steam. In fact, in the US, it already looks like we have reached the lows on this front. Even if there would be some volatility, the longer end of the curve should be relatively well anchored if markets perceive deviations from the downward trends in inflation as temporary bumps in the road that only delay the achievement of the inflation target.
This would be our base case. But if services inflation stagnates, while goods inflation reaches its lows, markets might question their current timeframe for rate cuts. In words of Fed chair Jerome Powell at the latest FOMC press conference: “Let me say that we have confidence. We're looking for greater confidence that inflation is moving sustainably down to 2%.”