Inflation is coming down fast. After 18 months of painful price growth, data over the autumn months across the US and Europe has been better than expected. Annual eurozone inflation in November fell to 2.4 per cent — within a whisker of the European Central Bank’s 2 per cent target. In America, it fell to 3.2 per cent in October, while in Britain it plunged over 2 percentage points to 4.6 per cent. The drop deserves celebration. But to declare an end to the inflation battle — as some are doing — smacks of complacency.
The main driving force behind falling inflation this year has been an easing in external price pressures. Europe was hit by a food and energy price shock following Russia’s invasion of Ukraine. But annual energy prices in the eurozone fell close to a record rate last month. And in the UK, food price inflation continued to fall. The US was more insulated from Vladimir Putin’s war, but it was hit by supply chain disruptions that lingered throughout the pandemic. Those strains have lessened now too.
With the effects of earlier price shocks fading, it is possible that the low-hanging fruits on the road down to 2 per cent have already been picked. Central bankers have repeatedly said the last mile, which involves taming growth in domestic goods and services prices, will be harder. They have an incentive to reiterate this message. Investors have become giddy over lower-than-expected inflation data and are pricing in rate cuts earlier than monetary policymakers are indicating next year. This has loosened financial conditions somewhat.
The problem for central bankers echoing the “last mile is harder” narrative is that core price inflation, which excludes food and energy prices, has recently turned a corner. In the eurozone, it is currently 3.6 per cent. The Fed’s preferred gauge of core US price growth is also now at its lowest since April 2021. Signs are increasing of a dimming in economic activity on both sides of the Atlantic. That would build the case to begin cutting rates sooner than anticipated.
But the cautious narrative is not all rhetoric. Although job markets have cooled, they remain tight. The Indeed Wage Tracker shows annual growth in advertised wages falling from their peaks, but they are still elevated. Data for the UK shows pay packets growing at 7 per cent in October. This is feeding into high services inflation — the largest component of the price indices. With productivity forecasts subdued, central bankers will want to see salary growth fall further to bring down core inflation, which is still higher than desirable.
There are also idiosyncratic factors and risks to consider. In Europe, the base effects of high energy inflation last year will become less favourable. Capital Economics expects eurozone inflation to rebound to at least 3 per cent in December. Pre-election giveaways in Europe and America could also nudge up demand. And, oil prices are shaky amid conflict in the Middle East. Slightly worrying too is the pick-up in long-term inflation expectations in the US last month, to their highest since 2008.
It is too early to declare mission accomplished. Central banks’ objective is, after all, to get inflation back to 2 per cent — and keep it there. Right now, there are risks on both sides.
With the impact of prior rate rises still feeding through — and real interest rates rising — central banks may well need to consider cutting strategies sooner in 2024 than they think. The probability of undershooting the target, particularly in the eurozone, has grown. At the same time, policymakers need to watch core inflation closely for signs of stickiness, and ascertain how medium-term dynamics such as demographic change, the AI revolution and geopolitical shifts may also influence prices. The mixed signals will be difficult to read. The last mile may indeed be the hardest.