18 JUL, 2023
By Alexis Bienvenu, Fund Manager, LFDE.
Recently published US inflation data for June is again reassuring at first glance, confirming an even higher than expected fall: 3% for overall inflation based on the CPI versus 4% in May, and 4.8% for underlying inflation versus 5.3% the previous month.
The base effect from energy prices is a key factor in the drop in headline inflation and should remain favourable in the coming months, as should food price developments. Households are particularly sensitive to these two factors, so this should help hold consumer expectations for inflation at a modest level. The US Federal Reserve (Fed) is surely breathing a sigh of relief at this news.
Still more reassuring, is the fact that less volatile underlying inflation is starting to show the full benefit of rent price moderation – or the equivalent of rental costs for homeowners – and this impact will continue to be felt throughout the coming six months.
Lastly, underlying inflation for services excluding housing, to which the Fed pays particular attention, is also clearly receding.
Equity markets in most countries rose significantly on the back of this data, and yield curves eased, having started the month inverted. Good vibes are rippling through the summer markets, but will they last?
Watch out for squalls. Firstly, recent statements from central banks have been tough on inflation: economic data, which is sensitive to base effects such as those linked to the immediate consequences of the war in Ukraine, must be considered in light of medium-term factors that are deemed more worrying, including wage inflation (which remains significant) and weak productivity growth, particularly for services. This is why the Fed, for example, has been issuing statements for a number of weeks that seem out of step with reassuring data linked to consumer inflation alone.
So is it about to make another U-turn and adopt a more dovish tone? We will have the answer at its next monetary policy meeting on 25 and 26 July, but it seems unlikely that it will diverge significantly from its hard-won offensive posture. In addition, it has indicated that it would prefer to run the risk of being a bit too restrictive for a while longer than loosening too early, especially as there are no concerns regarding employment.
There could be an upset in the medium term from a considerably less traditional inflation driver. It remains poorly understood and largely ignored by central banks (with the notable exception of the European Central Bank (ECB)), which have yet to come to terms with it and have only a vague understanding of its impacts: the climate. If we are to believe the research carried out by major economic institutions, it seems certain that global warming will have a significant inflationary impact in the coming years, estimated at between 0.32% and 1.18% per annum by the ECB. This risk is partly seasonal and difficult to quantify, and is, admittedly, mainly an issue for the long term. But it is also having a short-term impact. The ECB estimates that the heatwave in 2022 contributed in the order of 0.7% to food price inflation in Europe, and that such extreme events are likely to have an inflationary impact of close to 1% by 2035, representing a substantial element of long-term inflation momentum.
And meteorological bodies recently indicated that this June was the hottest on record, as was the first week of July. These records could be in part caused – or exacerbated – by the return of the “El Niño” phenomenon, which raises temperatures and aggravates extreme events. The short-term probability of such an occurrence is currently estimated at 90% by the World Meteorological Organization.
The sunshine currently prevailing on markets could therefore be spoilt by the return of persistent inclement weather caused by central banks or by physical factors. The latter cannot be forecast precisely, but their influence is now impossible to deny.
The sunny outlook for inflation could turn stormy.