When will inflation reach the magical 2% level? And what will happen when it does? Last week, there was an outrageous overreaction to the news that annual consumer price inflation had increased from 3.9% to 4%.
British bond yields soared, with the 10-year UK government bond rate rising to nearly 4%, while the Footsie fell 150 points, all due to modest increases in alcohol, tobacco and airfare prices.
But as anyone interested in markets can tell you, when they do seemingly irrational behavior, they are trying to tell us something else. Separately, it was a broader reassessment of the pace at which interest rates are likely to fall globally.
Perhaps rising inflation in Europe and the US over the past few months has made them change their minds. Perhaps the sharp drop in bond yields has made them a little too bullish. Central bankers have certainly tried to temper expectations about the pace of interest rate declines, as has the International Monetary Fund. Gita Gopinath, the fund’s deputy managing director, said the fund expects the rate cut to occur in the second half of the year rather than the first half.
Well, probably. But imagine what would happen here in the UK if inflation returned to 2% in April. That’s a real possibility. In fact, that’s what the forecasters at Pantheon Macroeconomic Consultancy expect, and I agree with them.
Indeed, last spring I expected the consumer price index to fall to its target level by the end of 2023, so the decline is about four months later than I thought. However, if you look at the trends over the past three months, the annual headline rate is already below 2%. It may recover next month, but there is a good chance it will fall to 1.5% by mid-summer.
Let’s think about its politics. There will be some kind of expansionary budget from Jeremy Hunt, and there will be a lot of pressure for more accommodative monetary policy.
The Bank of England will argue that it needs to focus on long-term trends and that cutting rates too quickly would be irresponsible. But just as we were too optimistic when inflation was trending upward, we are now too pessimistic as inflation is falling.
December’s CPI reading of 4% was disappointing, but much better than the central bank’s forecast of 4.6%.
The Bank of England is independent, and rightly so. We don’t want politicians to set interest rates like they did until 1997.
On the other hand, it is necessary to consider why the World Bank and other major central banks were so sluggish in their judgment. Reform is inevitable here and everywhere. If inflation actually falls below target, central banks will have a hard time justifying the delay in cutting interest rates.
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Other shifts are also available. It would look much more flimsy for companies to make exaggerated excuses when quoting prices. You cannot claim that general costs have increased when they are falling. Producer input prices fell 1.2% month-on-month in December.
Labor market stress has eased and most of us should be hopeful that the recent wave of strikes will subside. So a world with inflation back in its cage would feel more benign and less problematic.
Inevitably, there are many other things that can go wrong. The attacks in the Red Sea have doubled shipping costs in the last month, but that seems almost trivial in light of the broader conflict currently taking place.
We must always remember the human tragedy that is occurring alongside the economic damage. Even within the country, simply reducing the inflation rate will not solve everything.
But as summer rolls around, everyone will be more aware of something else: the upcoming general election. It is impossible to predict the political impact of navigating inflation, but it will establish a clear path to lower interest rates.
Coupled with the possibility of a tax cut, or more precisely a reversal of the previous tax increase, there are glimpses of positivity.
In fact, if you look at the housing market, it’s already showing up. US investment bank Morgan Stanley has just reversed its alarming prediction that house prices would plummet by 10%, and it looks like it’s about time. We haven’t reached the sunlit highlands yet, but as CPI dips below 2%, those highlands will be upon us.
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