Inflation: the last few miles

Alexis Bienvenu, fund manager at La Financière de l’Echiquier (LFDE)

Everywhere, inflation is on the ebb. In the United States, it fell back to 4% in May, having reached 9% in June 2022. In the eurozone, after peaking at over 10% in October 2022, preliminary estimates for June suggest it has dropped to 5.5%.

So, does this mean the battle is over? Sadly, no.

Firstly, although the trend for headline inflation is reassuring, this is much less true of underlying inflation, which is adjusted for the most volatile elements. This reached 5.3% in May in the United States and 5.4% in June (preliminary estimate) in the eurozone. In other words, it was higher than overall inflation in the United States, and at almost the same level in the eurozone. In both cases, the downward trajectory was only slight – there was even a small rebound in the eurozone.

The difference between the two types of inflation can mainly be attributed to the fall in commodity prices following their surge as a result of the war in Ukraine. European oil futures, for example, have fallen from over USD 100 a barrel in March 2022 to an average of USD 80 since the start of the year, and European natural gas has wiped out the price gains it made at the outbreak of the war.

But if core inflation is falling less rapidly than headline inflation, this is not solely due to the fall in commodity prices, which only benefits the latter. It is also because there are powerful factors driving underlying inflation, which Christine Lagarde, in her recent speech at the central bankers’ meeting in Sintra, described as relatively long-lasting and therefore worrying.

The first factor is wage inflation. In the United States, the average hourly wage rose by 4.3% in May. Granted, wage growth has fallen from a peak of almost 6% in March 2022, but it has hardly shown any downward movement for several months. In the eurozone, the European Central Bank expects to see wages rise by 14% by the end of 2025, or almost 5% per annum. While it may be good news for employees, this rarely attained level is causing concern in that there is a great deal of inertia, particularly in Europe where wage negotiations are often annual, creating the conditions for the possibility of lasting inflation.

Even more worryingly, this wage inflation is taking place against the backdrop of a particularly tight labour market, which is expanding much faster than in theory should be implied by the level of growth, which is manifestly weak – 1.3% for the United States and 0.6% for the eurozone in 2023, according to the Bloomberg consensus. This reveals a willingness on the part of companies to retain more workers than is strictly necessary, in a situation where available labour is scarce and therefore expensive. The resulting increase in unit labour costs has led to weak productivity growth. This, once again, is a long-term driver of inflation – and a drag on growth.

Finally, significant secular factors beyond the control of central banks are increasing the risk of inflation rather than inflation itself. In its speech in Sintra, the International Monetary Fund mentioned two of them: the fragmentation of world trade, and the risks associated with global warming.

Of course, other sectors of the economy are partly compensating for these upward pressures. In the United States, and gradually in Europe as well, property prices are easing. This is also the case for the price of certain manufactured goods, such as electronic chips, which had seen prices soar due to Covid-related disruption in manufacturing and transport chains. Most of these problems have now been resolved.

But in the non-housing services sector, which accounts for a very large proportion of the economy, inflation remains a threat in a way not seen in three decades. At just over 2%, the level may not be extreme, but inflation is proving stubborn. Reducing inflation from 10 to 5% was not difficult for the central banks: all they had to do was allow the excesses in certain markets to subside. But going from 5% to 4%, then to 3%, and ultimately to 2%, will be increasingly hard, especially if they want to avoid a deep recession.

The toughest part of a marathon is rarely the first half, but the last few miles, which seem to last for hours.