Market Updates

Can central banks tame inflation?

By Investment Desk | 28 Jul, 2022

Inflation will remain high through most of the second half of this year and in some countries, such as the UK, it will most likely move into double-digits during the autumn as planned energy hikes feed through. Over the past 2 years, inflation forecasting has been poor and has confounded most economists. A rapid move towards the target is unlikely, but nevertheless, many forecasters are predicting that early to mid-2024 could see a return towards normality.

Why has Inflation become a major problem?

  • A significant supply/demand imbalance as supply was constricted whilst demand for goods was booming, leading to massive supply chain disruptions.
  • Disruption in the labour market as economies reopened with excess demand and lower supply, forcing wages to rise.
  • A commodity price shock as supply was constrained, added by Russia’s invasion, leading to concerns over energy and food security as prices were forced higher under the weight of sanctions and lack of delivery.

The path towards lower inflation must deal with these issues, but particularly with the supply and demand imbalance that inspired price hikes. We can see that supply/demand imbalances and related supply chain disruption indicators have started to move in the right direction, and if consumer demand continues to weaken in coming months, it bodes well. It will most likely be a very slow process, but it could become quite pronounced if consumer demand weakens significantly in coming months leading to a reversion to normality in many indicators.

A second round of inflation from higher wages may well emerge as a bigger threat than the supply chain disruptions in coming quarters and is clearly a real fear for central banks. Given the tightness of labour markets, wage growth is likely to remain elevated for some time, and it will require a shift in employment trends to change the trajectory. But there are early signs, from Amazon to Walmart to Tesla to jobless claims, that the job market may just be beginning to shift the right way for inflation expectations. These are early days, but the labour market is a lagging indicator.

The commodity price trajectory, and in particular energy costs, is the most difficult to predict as it is mired in geo-politics and the length of the war in Ukraine. We have increasingly seen wild swings in oil and gas prices, some linked to new news but mostly large speculative moves. The forward-looking prices are still gradually downward sloping. If central banks succeed in lowering demand, it should eventually feed through into energy costs, alleviating inflationary pressures.

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