Has inflation stopped falling?

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Today, Japan ended an eight-year period of negative interest rates after gaining confidence that the country has defeated deflation for good. More on that below.

Similar fireworks are unlikely when the Federal Reserve and Bank of England meet later this week. Their meetings will be interesting for what they say. They come at a time when people are getting nervous that inflation is becoming sticky at levels that are too high and the problem lies in the services sector.

Claire Jones will be taking the hot seat next week to pore over the meetings and forecasts. But for now I would like to know your views. Is disinflation in trouble? Email me: chris.giles@ft.com

Sticky services

No one should care too much about movements in individual components of inflation, but many economists exempt the broad category of services from this rule because it has predicted overall inflationary trends well in the past. The services component is large — 61 per cent of the US consumer price index, for example. They are generally produced domestically and therefore fully reflect local economic forces. And services inflation is too high still. Everywhere.

Fed chair Jay Powell recently said it was reasonable to think goods price deflation had run its course, so “that would mean the services sectors would have to contribute more” to disinflation. President Christine Lagarde said the European Central Bank would be “laser focused” on services prices and the wages that underpin them before taking a decision to cut rates in June. So it is helpful to look at services inflation and ask what this tells us about bringing inflation down.

The evidence

The chart below is a fantastic resource and compares annual manufactured goods and services inflation across the US, eurozone and UK.

First look at the pre-pandemic period. Core goods inflation hovered around zero in both the US and eurozone. That would also have been the case for the UK were it not for Brexit, which hit sterling and raised imported goods prices after 2016. Services price rises in the eurozone were also below 2 per cent, resulting in persistently too low inflation, the need for quantitative easing and other unorthodox monetary policy. Paradoxically, that is everything hawkish central bankers like to avoid, so hawks should not want a return to this world. Services inflation in the US and UK at just above 2 per cent was healthier.

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The noticeable thing about the pandemic is that the US both had a much sharper rise in core goods inflation than Europe and that it came earlier. It suggests excess demand was operating there (in addition to the supply chain problems that the Bernanke Blanchard model found). In comparison, the eurozone saw industrial goods prices rising sharply after Russia’s invasion of Ukraine, indicating an embedding of high natural gas prices at a time when US goods price inflation was moderating sharply. Again, this demonstrates that the two sides of the Atlantic did not suffer the same inflation shock.

Services inflation has turned the corner and is declining everywhere, although the UK is a little behind its two big brothers. But services inflation still remains too high to be consistent with inflation falling to 2 per cent durably. In Europe, most of these big jumps in services price rises came almost a year ago and the signs are that annual inflation rates will fall.

The bad news out of the US this year has been that the same is no longer true of the latest consumer price data. Of course, the Fed really targets the personal consumption deflator (not the CPI) and the inflation in housing is both surprisingly sticky and likely to come down because the most recent new rents are not showing the same price hikes as those used in the CPI. But the latest data has been poor and is likely to make the Fed cautious. As the table below shows, the latest one-month, three-month and six-month annualised inflation numbers are higher than the 12-month rate, so it is no longer true to say we are just waiting for past large price rises to fall out of the annual inflation calculation.

Excluding housing, services prices have been rising at an annualised rate of 6.9 per cent over the past three months. That is not a sign of progress. Taking the median of all these inflation measures shows an annualised rate of 4.6 per cent over one month, gently declining to a 3.8 per cent rate over 12 months. It is not a cause for undue alarm, but the past two months of inflation data have been poor.

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Academic evidence

If the question is whether to worry about services inflation, there have been two recent international pieces of academic evidence, unhelpfully providing contradictory conclusions. The Bank for International Settlements quarterly review found that services inflation was not linked to previous energy price rises and therefore likely to pose an inflationary threat for longer. Its conclusion that interest rates needed to remain higher for longer was, however, rejected by separate research from Jan Vlieghe, formerly of the BoE, soon to be vice-chair at Millennium hedge fund, but currently writing as a researcher at the London School of Economics, who says there is much less to worry about after an energy shock.

The BIS paper is nice and provides the conventional wisdom that services prices reflect domestic inflation and are likely to persist. But a core reason it gets this result is that it estimates the impact of energy prices on services inflation from the 2011 to 2015 period. This is a serious weakness in explaining what is happening today. Vlieghe’s paper finds energy prices to be much more important in driving services prices by estimating the effect using the most recent data and exploiting the cross-country differences in energy price spikes that have been a feature of the past three years. He finds energy to be highly significant in explaining the differences in service sector inflation across countries — about half of it. It is powerful evidence.

This does not mean that the standard thinking that services reflect domestic inflationary pressures and that BIS research can be ignored. But it does suggest we should expect a significant part of recent services inflation to dissipate quickly after an energy shock.

The upshot

The eurozone and UK should keep an eye on services prices and wages, but central bankers should expect it to moderate now that natural gas prices have reversed. Having not suffered anything like the same energy shock, the US almost certainly has a more traditional services prices story and therefore more to worry about with persistence of inflation.

A nimble Bank of Japan

Earlier today, the Bank of Japan ended negative interest rates and raised its policy rate from -0.1 per cent to a range of zero to 0.1 per cent. Read this for the breaking news and Robin Harding, FT Asia editor and our former Tokyo bureau chief, puts the story in context here.

The mood music at the BoJ transformed last week after indications that large companies will offer the highest wage increases since 1992, indicating that a positive wage price dynamic is now operating. This is positive, but will not change the outlook hugely. A move had been expected in April in any case, and the BoJ has indicated it will keep rates accommodative “for the time being”.

The first move upward in rates is unlikely to push Japanese rates towards anything like those in Europe or the US. Even as the central bank has formally ended yield curve control it still says it will “make nimble responses”, raising the rate of asset purchases if market interest rates spike higher. Economic activity is still lacklustre, the durability of the wage price dynamic is far from secure and smaller companies are yet to offer similarly sized wage increases. I could show a chart of forward Japanese interest rates over the coming year, but it is identical to that a week ago. Longer term Japanese market expectations of interest rates have actually declined a little.

But let’s not get grouchy. The BoJ’s move demonstrates it knows how to take advantage of the situation and escape negative rates before other central banks start easing policy. This marks definitive progress and another step towards the normalisation of Japan’s economy.

What I’ve been reading and watching

  • US academic economists in the FT-Chicago Booth have been very consistent in their 2024 interest rate expectations. In early December 75 per cent thought there would be fewer than three rate cuts and now it is a little over two-thirds. I wonder if there would have been a different result if they had been asked in early January

  • The ECB published its new framework for setting interest rates, plumping for a demand-led corridor system. This was much as expected. With such a large balance sheet, it will not apply for some time

  • Argentina has managed a large debt swap, increasing the maturities of its debts, giving it breathing space and allowing interest rates to come down to a mere 80 per cent from 100 per cent. Recessionary forces are still increasing and inflation is far from beaten, however

  • If you want to read the optimistic take on China, Martin Wolf has been examining it

  • And if you want to be depressed that the Laffer curve rarely exists in practice, I went into the gory details from a UK perspective

A chart that matters

I am indebted to Robin Brooks, senior fellow at the Brookings Institution, for this lovely graphical representation of the reversal of the Santa rally in financial markets. In November and December, traders were certain about a huge number of rate cuts to come during 2024 and these have mostly been reversed (Australia and Switzerland being minor exceptions to this rule). The chart shows that financial markets still expect current policy rates to come down by the end of 2024, but not nearly as much as at the end of last year. Let no one say it is only central bankers who get their forecasts wrong.

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