A soft landing for the U.S. economy appears possible. Inflation continues to fall, squeezed by high interest rates, but we see relatively little harm done to the overall economy. Despite higher prices, consumption is being maintained by the drawing down of savings and by pay growth.
Risk assets have rallied in response, with the S&P 500 up 1.2% since the start of July and the NASDAQ by 2.3%.
But there remains a key statistic that needs to come down before we can say that the inflation story of the post-pandemic period is over. That is wage growth, which is now in line with core inflation and which is likely to slow the fall in inflation.
Indeed, the Fed’s 2% inflation target appears a long way off, when average hourly pay is rising at 4.4% and labour productivity growth is negative. For this reason, we must limit our optimism over a soft landing. It is possible, but it is far from certain.
The U.S. economy is slowing. We can say this with some confidence because last week’s June inflation numbers continued a trend of weaker-than-expected economic data. Headline CPI came in at 3%, the lowest since March 2021, and core inflation at 4.8% and falling. *
The data release had been preceded by a relatively weak June non-farm payroll report ten days ago,** and a weak ISM manufacturing report before that.*** And it was followed by producer price inflation last week, that came in below expectations. ****
Risk assets have rallied in response to this data. Investors hope that the Fed may resist raising interest rates next week (although a hike remains priced in by the markets). The ‘higher for longer’ interest rate scenario, that we have discussed previously, may be avoided.
It was not just the U.S. stock market that has rallied in response, the FTSE 100 and Euro Stoxx 50 both rose over 2% last week. On fixed income markets, yields have fallen with the two-year Treasury down from 5% on the 6th to 4.73% today. The dollar has weakened, given that other central banks (particularly in Europe) look set to continue to raise interest rates. The pound is up five cents this month, to $1.31.
What could go wrong?
But wage growth remains too high and casts a shadow over the above. The same data-dump that showed June non-farm payroll grow at the relatively modest number of 209,000, also showed average hourly wage growth rise in June, to 0.4% over the month (4.4% over the year), reflecting the still-tight labour market. The unemployment rate fell to 3.6%.
Therefore, while there is strong trend in the economic data to suggest that the U.S. economy is slowing and that the Fed may be able to hold off a rate hike next week, it is far from certain that enough slack is being created in the labour market at present to reduce wage growth and hence bring down core inflation to levels needed for the Fed’s 2% inflation target.
An added problem for the Fed is that labour productivity is negative. New hires in a tight labour market tend to be less efficient than existing workers, bringing down overall productivity. The ratio of wages to output increases, which is inflationary.
The Bureau of Labor Statistics report that in the first quarter of 2023, output increased 0.5% while the number of hours worked, to produce that output, increased by 2.6% (seasonally adjusted annual rates).***** This suggests a fall in labour productivity of 2.1%, and is evidence of a still-tight labour market.
Inflation and interest rates in the UK
Wednesday brings UK June inflation data. A Reuters poll of economists shows expectation of 8.2%, this compares with a rate of 8.7% in May.
Britain’s inflation problem is particularly stubborn. The economy has been affected by both the tight labour market problem seen in the U.S. and by the high energy costs of Europe. Its goods inflation came later than it happened in the U.S. and is taking longer to pass through. The Bank of England began raising interest rates before the Fed and the ECB, but has since, at times, appeared complacent.
More fundamentally, a weak skills base, Brexit, and unstable government policy have deterred investment and hindered productivity growth. A long-term dependence on imported food means that falls in global soft commodities are not reflected in falling shop food prices, as rising handling and transport costs push up end-prices. A British shopper would be surprised to learn that U.S. wheat prices are down from $9 a bushel at the start of the year, to $7.10 today.
Markets are pricing in at least 1% more rate hikes from the Bank of England, between now and early 2024, which would take interest rates to 6%.
The ‘higher for longer’ interest rate scenario appears a near-certainty for the UK, making it difficult for small businesses to grow, and threatening weak companies’ existence. Rising mortgage costs add to cost-of-living pressures for those who are unable to achieve inflation-matching pay rises.
In the UK, as elsewhere, it will be these people who end up carrying the burden of inflation: the pensioners on fixed incomes, the un-unionised, and the low skilled workers.
Investors should remain diversified, by asset class (e.g., equities and bonds), geography and by currency. Financial history shows that such an approach delivers the best risk-adjusted returns.
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