Normally, the great challenge in talking about the global economy is finding a theme. The economic fortunes of nations are usually driven by such a disparate array of political, financial, demographic and environmental crosscurrents that is impossible establish a framework for analysis. Twice however, in this still young century, events have unfolded to provide just such a theme as the world battled the global financial crisis in 2008 and the global pandemic in 2020.
In 2022, there is also a unifying theme—higher inflation across almost all major economies. However, even here there are significant differences in the degree of inflation that countries face, the underlying causes of the inflation, prospects for inflation going forward and the steps central banks are willing to take to combat it. As summer winds down and investors need a quick update on the global financial environment, one convenient short-cut is simply to look at the war on inflation across the United States, the Eurozone, the United Kingdom, China and Japan.
The United States: An Inflation Cold Front Moves Through
In the U.S., last week finally brought distinctly better news on inflation. In July, on a month-over-month basis, headline CPI was unchanged, producer prices fell 0.5% and import prices declined 1.4%. However, on a year-over-year basis, that still leaves CPI up 8.5%.
8.5% year-over-year is, of course, better than the 9.0% gain posted in June. However, it is still higher than in any month in the forty years between 1981 and 2022. There is no doubt that part of the U.S. inflation problem, as elsewhere in the world, stems from the supply disruptions of the pandemic. However, aggressive fiscal policy also played a role as the federal government boosted the budget deficit from an already very high 4.7% of GDP in fiscal 2019 to 15.0% in 2020 and 12.4% in 2021. Importantly, the majority of this fiscal stimulus was aimed at middle and lower-income households, who responded, unsurprisingly, by sharply increasing their consumption of goods.
In addition, years of very easy money from the Federal Reserve, while not generating much of a boom in home-building, did contribute to a boom in home prices. These higher home prices feed (with a lag), into both actual rent and owners’ equivalent rent which, combined, account for over 30% of headline CPI. Finally, in February 2020, just before the pandemic started, the U.S. unemployment rate fell to 3.5%, its lowest rate since 1969. This had already led to a gradual increase in wage gains from less than 2.0% year-over-year in 2012 to over 3.0% in 2019. With labor force growth slowing due to the retirement of the baby boom and a sharp drop in immigration, wage growth was primed to accelerate as the economy recovered from pandemic shutdowns.
Finally, even with all of these pressures, inflation might have peaked earlier in 2022 had it not been for the impact of Russia’s invasion of Ukraine on global energy and food prices and the disruptive effects of China’s attempts to suppress the Coronavirus.
Having said all of this, there is a good chance that U.S. inflation has now peaked. Gasoline prices have fallen on a daily basis for two months while airline fares, hotel rates and used car prices are also falling. In the medium term, despite a strong July jobs report, the U.S. economy has clearly lost momentum with real GDP declining in both the first and second quarters. A continued drop off in fiscal stimulus, despite the passage of some key legislation recently, will also tend to depress growth and inflation as will the impact of high dollar on trade and the effect of higher mortgage rates on housing, (which should be visible in this week’s Housing Starts and Existing Home Sales reports).
At his last press conference, following the Fed’s July 26/27 FOMC meeting, Chairman Jerome Powell acknowledged that the last two 0.75% Fed rate hikes were aggressive but that the Fed would be data dependent and could be equally aggressive at their September meeting, if the data warranted it.
The crucial point, of course, it that it looks like the data won’t warrant it and, as of now, we expect the Federal Reserve to raise rates by 0.5% in September, 0.25% in November and 0.25% in December, leaving the federal funds rate at between 3.25% and 3.50% and holding at the end of the year.
The Euro Zone: Still Waiting For An Inflation Peak
While there are strong signs that inflation has peaked in the United States, the story is less clear in the Euro Zone. In particular, consumer prices registered an 8.9% year-over-year increase in the flash estimate for July compared to 8.6% for June. While the Euro Zone was more successful that the U.S. in limiting the spike in unemployment during the pandemic, they achieved this with less fiscal stimulus, limiting both the pace of economic recovery and the feed through to lower unemployment and higher inflation. By the first quarter, employment costs were up a moderate 3.8% year-over-year (compared to 4.5% in the U.S.) and the unemployment rate, while low by European standards at 6.6% in June, was still far above the 3.6% seen in the U.S.