In his regular look at the economy, Jeff Lewis, director at RobMac, considers upcoming indicators that point to which direction financial markets are heading.
This is a big week for data in the UK and US. The results will provide clues as to whether the Bank of England (BoE) and the Federal Reserve will continue to raise interest rates and that depends on whether they think they are winning the war against inflation. In our view there is a very good chance that US inflation is on course to return sustainably to the 2% target. We have much further to go in the UK but our guess is that we are on the right course too.
We get the US consumer price data on Wednesday, which is hugely important for markets. At first sight the numbers might look disappointing: headline inflation will probably increase for the second month in a row to 3.6%, up from 3% in June. But core inflation is likely to fall significantly and, although it remains well above the Fed’s 2% target, it looks set to fall further. Rent is the biggest component and is clearly slowing as is Wage Inflation. An Investment bank assessment has analysed comments made by corporates as part of the recent earnings season and the message is clear: the labour market is softening and pay pressures are easing. We may get one more rate hike from the Federal Reserve but that should be it.
If that is right then the question becomes: when will they start to cut interest rates? A few months ago we had expected the Fed to be cutting rates by year-end in the face of a significantly weaker US economy. But it has proved to be highly resilient. As long as unemployment remains low, the Fed will keep rates high until they are confident inflation is beaten. Our assessment is they will start cutting early in 2024.
The situation in the UK is quite different. Headline inflation has fallen, and will fall further, but core inflation is far too high – almost 7%. Wage inflation is also far too high. The BoE is set to raise rates again when it meets later this month but we are much more optimistic than many about UK inflation. Weak sterling last year accounts for almost two percentage points of current inflation. That effect should disappear and turn into a favourable influence as a result of this year’s strength in sterling.
Although petrol prices are set to rise following the recent increase in global oil prices, that effect will be swamped by slower food price inflation and falling household energy bills. Data this week is likely to show a significantly weaker labour market – much weaker than the BoE expected. With headline inflation set to tumble, we could get the wage price spiral operating in reverse. The BoE is understandably shocked by the rapid rate of recent wage inflation, but that reflects catch-up from higher inflation earlier this year, coupled with the 10% increase in the minimum wages, which now affects two million workers. Wage inflation is set to slow significantly.
If its right , then UK base rates are close to the peak. Like its US counterpart, the BoE would then keep rates on hold until it is confident that inflation is returning sustainably to the 2% target. That may take some time, unless unemployment increases significantly as we approach winter.
Either way, markets, and especially bond markets, should be relieved that the rapid rise in official rates is drawing to a close.
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