Will There be a Second Wave of Inflation?

No, we expect Consumer Price Index (CPI) inflation will continue to moderate toward central bank target levels in 2024. As a result, we believe key central banks will cut policy rates modestly this year to avoid overtightening. This should support our view that investors should hold a modest overweight to long Treasury bonds.

Global inflation fell sharply in 2023. One broad measure of G7 economies indicates inflation fell to 3.1% year-over-year in November 2023, down from 7.3% one year earlier. So far, the decline in inflation has been primarily driven by lower commodity and goods prices, which have come down due to a normalization of supply chain disruptions. Services inflation has been slow to moderate and, given recent shipping disruptions in the Red Sea, some have wondered whether inflation may again accelerate. We doubt it.

Shelter prices were one of the biggest contributors to sticky services inflation in 2023, particularly in the United States. US shelter prices rose 6.2% over the last year in December, accounting for more than two-thirds of the 3.9% increase in US CPI excluding food and energy (i.e., core CPI). Elevated shelter prices have led to a divergence between two key measures of inflation, core CPI and the core Personal Consumption Expenditures (PCE) Price Index, the Federal Reserve’s preferred metric. The latter has a much lower weight to shelter and rose just 2.9% year-over-year in December, which is a full percentage point less than core CPI! In fact, core PCE is below the Fed’s 2% target over the previous six months. Further, real-time indicators of rental prices, such as the New Tenant Rent Index, point to a steep decline this year in shelter inflation, which is itself a notoriously lagging indicator.

The trend in core services ex shelter prices, or “super-core” inflation, also appears to be headed down. Prices of these services are closely monitored by central bankers as a signal of cyclical inflation because of their tight relationship with labor market conditions. Resilient growth and tight labor markets supported wages and the prices of some core consumer services in 2023. This likely isn’t sustainable. Tight monetary policy and fading consumer tailwinds (e.g., a decline in excess savings) both point to a more challenging growth environment going forward. Analysts project real GDP will expand just 1.5% in the United States, 0.5% in the Eurozone, and 0.3% in the United Kingdom this year. And while labor markets are tight, they are softening. For example, a decline in US job openings and quit rates has already put downward pressure on wages. The US Employment Cost Index rose by a relatively weak 0.9% in fourth quarter 2023. The anticipated downshift in economic growth should accelerate this process and, in turn, pull down wages and super-core inflation.

As previously mentioned, the initial fall in inflation has mostly been driven by the normalization of supply chains. This process is now mostly behind us. The latest reading of the Fed’s Global Supply Chain Pressure Index is back in line with its historical average after spiking during the pandemic. However, lower commodity prices, stable input costs, and an expected downshift in global growth all suggest goods categories will likely continue to be a source of disinflation. Recent shipping disruptions in the Red Sea have led to an increase in global freight costs and a marginal deterioration in supplier delivery times. However, the disruption to date pales in comparison to the pandemic and the broader price impact appears modest.

Major central banks in recent months have opened the door to the possibility of cutting interest rates in response to the accelerated decline in inflation. Central bankers face two-way risks as they attempt to appropriately calibrate the timing and magnitude of cuts. Wait too long, overtighten, and cause a recession, or ease too much, too soon, and cause inflation to reaccelerate. In our view, the broad trend in inflation remains down and this calls for most global central banks to at least modestly lower policy rates this year. The combination of lower inflation and policy rates should pull Treasury bond yields down across the curve and cause yield curves to steepen. As such, we continue to recommend a tactical overweight to US long Treasuries.

TJ Scavone, Senior Investment Director, Capital Markets Research