The global economy continues to face the aftermath of the two-stage inflation shock, first pandemic, then energy. Monetary policy has since corrected the ultra-expansionary monetary stance. However, the immediate dominant macroeconomic issue remains the excessively high inflation trend.
No “No Landing”
Hopes that inflation would fall as quickly as it rose (Immaculate Disinflation) were dampened. The “No Landing” scenario was just flawless (Goldilocks). The somewhat more realistic assessment, according to which weak demand (“soft landing” including stagnation or even mild recession) could reduce inflation, has also become less likely. In both scenarios, key rate cuts were conceivable from the second half of the year, which would have supported the markets.
Inflation rates were too high in some countries in January, many important economic indicators rose and unemployment rates remained very low. In the US, the deflator (the inflation rate) for personal consumption expenditures was above expectations in January (0.6% month-on-month). Excluding the normally volatile components of food and energy, the price increase was also 0.6%. If this figure is extrapolated for the year (0.6% times 12 months), the annualized value is around 7.2%.
This value is far from a development with which the central bank can be satisfied. At the end of the week, the focus in the euro zone will be on the flash estimate for consumer price inflation for the month of February. The consensus estimate expects an unchanged high value for the core rate (5.3% yoy).
The aggregate flash estimate of purchasing managers’ indices (PMI) for major developed economies showed an increase for the second consecutive month in February. The PMI for the manufacturing sector indicates a bottoming out or slight growth. Global manufacturing contracted in the fourth quarter. The services PMI rose more than the manufacturing PMI. With a value of 51.5, the indicator is now back above the theoretical threshold of 50 that separates expansion from contraction.
With regard to the subcomponents, the increases in new orders and sentiment are worth highlighting. The employment sub-indicator has also improved. However, due to the tight labor market (low unemployment rate), there are risks of secondary round effects (excessively high wage growth). At the same time, it is worrying that the indicator for sales prices in the service sector did not continue the downward trend with a slight increase. This development provides an indication that companies have pricing power.
The assessment that the disinflation process will be slower than hoped for and bumpy is becoming increasingly accepted as the baseline scenario. The risk of inflation persistence becoming too high or of a renewed acceleration of inflation has even increased.
Central banks were unable to do much about the supply-side shocks (high energy prices, supply bottlenecks). However, the underlying monetary policy stance was (much) too loose in hindsight. This environment has facilitated pass-through and secondary round effects. Currently, the combination of too high inflation rates (a too-slow disinflation) and rising economic indicators is worrying central banks. The risk of anchoring inflation expectations at a level above the central bank target (of 2%) has increased.
However, central banks can affect demand (economic growth) with a restrictive monetary policy. The probability of additional key rate hikes has increased. In the USA, further interest rate hikes of almost one percentage point are included in the market prices until July (upper band for the effective key interest rate currently: 4.75%). In the euro zone, too, a key interest rate increase of around one percentage point is priced in by July (deposit facility currently: 2.5%). However, this has also increased the risk of a recession triggered by the central banks.
Central banks and probably also some market participants now have little confidence in their own forecasts of inflation and economic growth. Consequently, they are acting even more than before on published indicators. However, these are prone to fluctuation. Since the beginning of February, expectations for future key interest rates have risen, putting bond and equity prices under pressure. Higher interest rates reduce the present value (current value) of future cash flows (dividends, coupons). In addition, the increased probability of recession in the medium term reduces expected profits. However, one or the other unexpectedly rapid fall in inflation would once again support share prices.
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Prognoses are no reliable indicator for future performance.