The headline CPI has fallen from just over 9% in June 2022 to just 3.2% at the last reading. 

Annual inflation rates have come down but, on the flipside, there still seems to be evidence that inflation rates won’t come back to target levels. That leaves central banks, and financial markets in a quandary.

For many, the fall in headline inflation has been pretty significant. In the US, for instance, the headline CPI has fallen from just over 9% in June 2022 to just over 3% at the last reading. That’s only around half-a-percent above the level we saw just before the pandemic broke in early 2020. It is easy to say now, but such a fall was always likely as base effects and the unwinding of food and energy price rises resulting from the pandemic and the war in Ukraine, have helped to lower price pressure. It is a bit like saying that the easy part in getting inflation down has been done, largely because inflation has come down of its own accord and there’s limit ed evidence so far that monetary tightening has done much to reduce inflation.

For instance, unemployment rates are still pretty close to pre-pandemic levels in many countries and if tighter monetary policy is supposed to work in reducing inflation by slowing the economy and reducing employment, there’s been very little evidence of this so far. Of course, interest-sensitive sectors of the economy have been hit by rising rates, particularly housing but, in the US at least, there are signs that this impact has all but vanished. Now none of this should take away from the fact that we have not just seen headline inflation fall.

We have also seen some evidence that underlying price pressure has eased. In the US, core CPI services prices excluding housing, which is the measure the Fed likes to use when applied to PCE prices, has shown an average monthly rise of just over 0.1% in the last four months compared to over 0.4% in the four months before that. Yesterday’s CPI data continued this trend and now the core services CPI ex housing stands at a 4.1% annual rate compared to a peak of 6.5% in September 2022.

So, what we can say about inflation, at least in the US, is that there has been both a big fall in annual headline terms, thanks to base effects and food/energy price moderation, as well as a reduction in underlying inflation that bodes well for the persistence of lower inflation in the future once any food/energy distortions have unwound. So far, this all looks quite good.

But the key question is this; is inflation coming down to the 2% target level for PCE prices, or will it stabilise at a higher rate? Mr. Steve Barrow, Head of Standard Bank G10 Strategy argued a long time ago, and still take the view, that it is on course to stabilise at a higher rate. Why? There are a number of reasons.

The first is that policy has not been tightened sufficiently to crush the economy and so reduce longer-term inflation expectations. The University of Michigan 5-10-year inflation survey is still sitting at around 3% having been close to 2% before the pandemic. A corollary of this is that the labour market is tight, and likely to remain tight for some time, so keeping upward pressure on wages.

Another factor is that inflated balance sheets of the central banks, thanks to quantitative easing, has also deadened the impact of high policy rates because long-term rates have been kept artificially low thanks to hefty prior bond purchases by the central banks. With all this in mind, the key question is whether central banks will keep their foot hard on the monetary brake until inflation reaches 2%, or will they accept inflation modestly above target while arguing that their forecasts point to price growth falling to target over time?

Mr. Steve Barrow’s view has always been that they will allow some leeway. They won’t act like monetary policy nutters, hell bent on hitting the target whatever the cost. This preference comes from the likely asymmetry that’s in the Fed’s average inflation target strategy adopted in 2020. The bottom line is that rate cuts in the US seem likely from next summer whether inflation is close to 2% or not.