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A turning point?

Uncertainty continues to reign over the economy. Growth is weak. Money is tight. What are the consequences of all this? In today’s edition of the Economic Brief, we take a look at three topics to better understand the situation: uncertainty in economic forecasts and what that means for business and economic agents; easing monetary conditions in the United States and the eurozone; and disinflationary trends on both sides of the Atlantic, but why our American friends appear to be in a stronger position.

 

UNCERTAINTY CONTINUES TO PERMEATE

Recently, the economy has faced a succession of crises, shocks and changes. These have required governments to adapt their policies and economic agents to adapt their behaviour. The events touch on all areas: on the supply side, they include digitalisation, ageing populations and international trade barriers, for example; in terms of demand, they include the need for investment in the energy transition, increases in defence spending and changes in regional trade flows. As for prices, we could mention new trends in commodities and salaries.

“Major” forecast errors for consumer prices in 2021 and 2022

But these crises cannot be considered separately, and their interdependency makes the already complex task of forecasting all the more complicated. A corollary of this seems to be an increasing level of divergence between forecast and actual figures. To illustrate, the graph opposite shows the growing variances in forecasts of consumer prices across multiple regions. Yet, forecasting is essential; it informs innumerable political, economic and business decisions across the world. If we can no longer rely on it, can we truly make decisions with confidence?

EASING MONETARY CONDITIONS

Federal Reserve – Ceiling no doubt reached

When we examine current monetary policy, two factors must be considered: the current weak levels of economic growth and slowing inflationary trends. With these in mind, it might be fair to say that monetary tightening is behind us – at least according to the market.

Indeed, based on the graph opposite, which illustrates the market’s perception of the implied policy rates and future priced-in hikes and cuts in the US, we have reached a ceiling, and from spring 2024, we can expect to see policy rates fall. The same situation applies to the ECB. A note of caution, however: the market has not been particularly successful in reading signals over the past few quarters; taking these predictions with a pinch of salt would be wise

 

At what point in the interest rate cycle should you buy financial assets?

In light of the optimism surrounding easing monetary conditions, investor activity is high. Indeed, when we look into the ‘right’ time in the interest rate cycle to buy financial assets, a clear pattern emerges, as illustrated in the graph opposite. Across all three categories of financial asset – shares in major corporates (S&P 500), shares in smaller cap corporates (Russell 2000) and long treasuries – the best threemonth returns were achieved when buying at the peak of the rate rise cycle. So, if we are to believe the market, it would appear that the best time to buy is now.

 

INFLATION ON BOTH SIDES OF THE ATLANTIC

Observing the trends in both general and core consumer price inflation in the US and the eurozone, we can see a clear deceleration, good news for the economy and for consumers. The question now is where will it stop? Will we return to the status quo of before the pandemic (i.e. around 2% in the US and 1.5% in the eurozone) or somewhere else entirely?

United States: back to normal for goods, not for services

Let us zoom in on the US. The graph opposite shows us the split of core inflation between goods and services. As we can observe, the curve for goods has returned to its normal level; the curve for services, however, remains much higher.

Diverging messages on each side of the Atlantic

Of course, as we have said in the past, the background trend underlying core consumer prices tends to follow unit labour costs – the development of compensation over output or productivity. We must therefore consider the dynamics for these two inputs: in terms of compensation, the tight labour market necessarily calls for a higher rate than before the pandemic; in terms of productivity, convictions are less clear-cut, with tensions in the labour market suggesting underperformance, but more vigorous investment would lead us to conclude the opposite.

So, what can we see? The unit labour cost in the US is slowing considerably, a consequence of the increasing productivity in the country; in the eurozone, however, the unit labour cost continues to rise. It looks like the disinflationary trend in the US might be a safer bet than its European equivalent.

 

Economic-brief-December-2023