Higher-than-expected inflation is raising questions over the likelihood of a ‘soft landing’, a scenario that needs inflation to slow, so that central banks can start cutting policy rates this year. Hotter services inflation in the eurozone isn’t helping.
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It all began with January’s US consumer price index (CPI) data, which came in higher than expected. Of particular concern was the increase in the monthly rate of core (ex-food and energy) inflation, which rose notably from 3.4% (annualised) to 4.8%.
Part of the increase came from the shelter (or housing) component of the index due to changes in the Bureau of Labor Statistics’ methodology. But the services index also jumped, overall and across several sub-indices.
More alarm bells rang when data for the eurozone showed a similar rise in services inflation.
The eventual release of the personal consumption expenditure (PCE) data (the US Federal Reserve’s preferred measure) confirmed the jump in the CPI.
The market’s initial reaction was to believe that the ‘soft landing’ narrative — that inflation would continue to slow, allowing central banks to make numerous reductions in policy rates over the course of the year — was now at risk.
Overheating fears eased by disappointing data
Instead, investors seemed potentially to be facing a re-acceleration in economic growth, which meant inflation might not fall so fast and central banks would not cut rates by as much as hoped. Expectations for the level of the benchmark US fed funds rate at the end of 2024 consequently rose.
These overheating fears were assuaged by generally disappointing economic data over the last few weeks. Whereas normally one might expect risk assets to react poorly to weaker growth, in the current environment it was perceived as good news since the market could again look toward policy rate reductions (see Exhibit 1).
Support for the view that economic growth was slowing came from the latest purchasing managers’ indices (PMIs). Most of the figures came in below market expectations and presented at best a mixed outlook (see Exhibit 2). The strongest data was for the services sector, with most of the indices above 50, indicating expansion.
The notable exceptions were Germany and France. Even there, though, the data was somewhat less bad in February than it had been in January. For other countries with expanding services sectors, the numbers deteriorated, the US being the key standout.
Exhibit 2
Purchasing managers’ indices (PMIs)
Data as of 8 March 2024. Sources: S&P, ISM, BNP Paribas Asset Management.
The manufacturing sector continued to struggle globally, with most indices below 50, though again, many showed an improvement in February.
It is difficult to assess the state of the US manufacturing sector. One index, the Institute for Supply Management’s (ISM) manufacturing PMI, worsened in February and still pointed to contraction, while the S&P Global PMI index improved and continued to signal an expanding manufacturing sector.
Such divergent data reflects differences in survey methodology, with the S&P Global survey covering more companies, while the ISM survey addresses a wider range of businesses.
Beijing – Must try harder
China’s PMI data showed little change versus January in either manufacturing or services.
Investors have been focused on the annual ‘two sessions’ congress which ended on 11 March to assess whether the government will take more significant measures to support growth. Its target of around 5% GDP growth for 2024 (similar to the 2023 target) will likely require additional efforts by Beijing – last year’s post-Covid reopening surge in consumption will likely fade, meaning an equivalent growth rate in 2024 will be harder to achieve.
The reaction of Chinese equity markets so far would suggest at least some disappointment. The MSCI China index fell by 1.8% last week (in USD terms), while the MSCI All Country World index gained 0.6%. The domestically focused MSCI China A index did a little bit better, rising by 0.1%, but still lagged global equities (see Exhibit 3).
Mixed US employment data
Other recent key data included US non-farm payrolls, which also painted a mixed picture. Non-seasonally adjusted payrolls rose by more than would have been expected at this time of year, but the strong readings from prior months were revised downwards.
The number of jobs created over the preceding 12 months was steady at 175 000, down from the 300 000+ rate of a year ago. The unemployment rate rose slightly, and the participation rate was unchanged. Participation actually rose for those aged over 24, but this was offset by a fall in the participation rate for younger people.
The pivotal figure for the question of whether inflation was reaccelerating was the change in average hourly earnings. The increase in services inflation is likely due at least partly to higher wages, and if the rate of earnings growth accelerates, services inflation might also do so. The data, though, showed a deceleration from 4.4% year-on-year to 4.3% (see Exhibit 4).
While encouraging, the rate has been at or above 4.3% since October, whereas the US Federal Reserve would likely be more comfortable with a 3.5% rate of increase.
Slowing growth and sticky inflation show that the possibility of stagflation cannot be entirely dismissed.
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