Rebottling the inflation genie can prove challenging

The latest data suggest inflationary pressures remain stubbornly high. For example, while headline inflation decelerated in the US in August, at about 8%, it remains extremely elevated and has not slowed as much as had been expected. Similarly, Eurozone inflation continues to set new record highs, while inflation in the UK remains close to double-digit levels and is feeding through into higher expectations for the future.

The composition of these inflationary pressures differ by region: Europe being much more exposed to the shock in energy prices for example. But the broad trend is the same. Underlying inflationary pressures have been on the move. Once the inflation genie is out of the bottle, it can prove challenging to put it back in.

Inflation won’t stay this high forever 

The market is pricing inflation to have already peaked in the US. In the UK and Eurozone, a peak should not be too far off.

As we move into 2023, a number of factors should put some downward pressure on headline price pressures. For example, Markets 360’s latest Supply Chain Disruption Tracker highlights some easing in disruptions which should help lessen price pressures further up the price formation chain.

Encouragingly too, energy prices have fallen from their recent highs, while governments have stepped in to cap price rises and/or mitigate the spillovers from wholesale energy costs to the costs faced by businesses and households. Even assuming energy prices stay at their elevated levels, the contribution of energy to the annual rate of inflation will diminish over the course of 2023.

Pricing power is increasingly constrained  

Inflation and economic uncertainty have started to impact consumers’ discretionary spending. The Q2 results season was rather informative in that aspect. Chip makers, for instance, now expect demand slowdown to expand beyond PCs and smartphones from Q3, and a number of retail giants have made recent profit-warnings, forecasting falling sales as consumers return from holidays and start to pull back on spending.

The squeeze on the cost of living for households is very significant. The Bank of England actually calls it the worst it has seen in more than 60 years. On the ground, major retailers in the UK have already guided towards lower profits this year, planning to absorb some of their cost inflation and keep prices low for shoppers.

Not all business models and sectors have enough room margin-wise to absorb this level of cost inflation. With demand rolling over, repricing effectively becomes more difficult, in particular in the poorest countries where households allocate a bigger share of their income on essential goods.

Risks remain on the upside 

Forecasters and policymakers alike have been humbled by the continuous surprises on inflation over the past eighteen months or so. As a result, it is important to keep in mind that risks around forecasts remain extremely elevated relative to normal.

For example, notwithstanding some of the recent policy proposals from the EU, Europe still faces material risks of gas supply shortages this winter. Such scenario would have major implications for economic output and inflation.

Similarly, risks on food inflation remain on the upside. Crop futures may be back to their pre Ukraine/Russia conflict levels, but the threat of drought and flooding in some key markets are keeping supplies tight and prices generally elevated.

Underlying inflation to continue to build 

Wage inflation is already strong in the US and rather sticky at about 5%, leaving the Federal Reserve concerned and keen to keep rising interest rates despite a deteriorating macroeconomic outlook. As Markets 360 Chief US Economist Carl Riccadonna has pointed out, “policymakers are not catching any breaks from the economic data yet, as the latest CPI report attests, so the march above a neutral setting will proceed at a steady pace for some time longer.”

In Europe, wage inflation is relatively limited so far, hovering around the 2% mark. But we expect wage growth to build further over the coming quarters, as workers try to find compensation for the hit to their real incomes against a backdrop of a very tight labour market.

From a business perspective, wage inflation is a double-edged sword. On one hand, it allows firms in a high inflation environment to pass the higher operating costs to consumers. On the other hand, it implies margin squeeze as higher labour cost comes at a time when all other expenses (raw material, transportation and logistics etc.) are also rising.

On top of this, and as Markets 360 economists have argued, the global economy is undergoing a number of more structural shifts that affect the economy’s supply potential, including both de-globalisation and de-carbonisation, which they view as more persistent drivers of inflation in the medium term. As Global Head of Markets 360 and Chief Global Economist Luigi Speranza has long argued: “global inflation will likely prove to be sticky.”

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