In this final edition of the Economic Brief before the summer break, we will investigate three areas of interest: decreases in interest rates, with many central banks across the world cutting rates for the first time in years; the valuations of US listed companies, which have risen significantly; and role of corporate profits contributing to the inflation experienced over the past few years.
Decreases in interest rates are finally on their way, heralding what seems to be the end of the rampant inflation plaguing us over the past few years. From Chile to Denmark, central banks are cutting rates for the first time in years. But this good news should be taken with a pinch of salt. The cuts are coming slower and later than originally forecast, so the high interest rate environment will continue to exact a toll for some time to come.
One of the central banks to have cut its base rate is the ECB. Indeed, for the first time in its history, it has decided to cut before the Fed, which maintained its federal funds target rate at 5.5%. Might this indicate a growing independence of the ECB vis-à-vis the Fed? Probably not. There are two reasons for this: first, the economic cycle is often closely linked on both sides of the Atlantic, so the central banks must pay attention to each other; second, Europe must be wary of any impact on the EUR/USD exchange rate for fear of importing inflation and undermining the progress made so far in the region.
Another area of particular interest at the moment is the valuation of listed shares in the US. If we take the cyclically adjusted price-to-earnings ratio, as put forward by Robert Shiller, an economist, we see that the average value has grown from 15 in the period before 1995 to 28 in the period since. Why is this the case? We can make various arguments. High and unstable inflation used to explain low valuations, but this relationship is no longer obvious. Less frequent recessions since 1980 have reduced investors’ perceived risk, boosting valuations. The rise of high-growth technology companies with lower capital content has lifted valuations measured at index level. High profits that have been trending upwards for a long time contribute to confidence in equities, so why not pay a premium? All these and more contribute to the rise in the ratio. However, it is worth noting that over the same periods, the yield on these shares relative to the yield on treasury bonds has decreased. Is everything changing?
Our last topic of note is on the role of corporates in driving, at least in part, the inflation experienced over the past few years. Let’s consider the US case. A recent study by the San Francisco appointment of the Fed looked into this very matter. Some of their key findings were as follows:
- Since 2021, unit margins had risen in some industries (vehicles, oil), but overall they remained stable, while inflation had risen by over 10%.
- Price-setting power has increased in some sectors but has not largely influenced overall inflation.
- Production costs are key. Increased demand and disruptions to supply chains have raised the prices of intermediate goods, contributing to inflation.
Perhaps more interestingly, the same study found that in periods of stronger inflation, even if some disinflation begins to take hold, unit margins rise. Take for example, the case of the 1990s shown opposite. But in periods where disinflation is strong – consider the 2000s and 2010s opposite – corporates’ ability to act on their unit margins is generally weaker, resulting in more stable figures. It would appear that certain corporates take advantage of the uncertainty inherent to periods of inflation to raise their margins, thereby (inadvertently?) contributing to the inflationary trend.
