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By François Rimeu, Senior Strategist, La Française AM
Inflation is one of the main topics (if not THE most important) for financial markets right now, and it could remain the case for at least the next six months. We will try to review in this paper what “could” happen on the inflation front moving forward, what are the risks and what does inflation mean for central banks. As an introduction, it is important to emphasize that nobody knows what will happen, that uncertainties remain high and that there is virtually no past reference period that we can refer to to estimate how and when inflation could come down. We will therefore try to analyse what the most probable outcome could be.
We expect Eurozone inflation to average 4.7% over 2022, 150bps above the European Central Bank’s (ECB) estimate in December, and core inflation to average 2.7%, 80bps above the ECB’s estimate. More specifically, we expect headline inflation above 5% at least until June, followed by a slow decline in Q3 and a more pronounced decline in Q4. We expect headline inflation to stand at around 3% at year end and core inflation at around 2.3%. Base effects will become very negative in the coming months (because of energy prices and supply disruption).
Higher natural gas and oil prices explain most of the upward revisions since the beginning of the year. In terms of energy outlook, the situation remains highly uncertain with some bullish factors that will likely end at some point while others could last longer (i.e., energy transition in Europe leading to gradual closing of coal and nuclear power plants in some European countries). Additionally, the Ukraine / Russia crisis is adding some uncertainty around the supply of natural gas.
Food inflation is also trending higher which is not a major surprise considering that leading indicators (fertilizer prices for instance) have also been trending higher for some months. Here again uncertainty remains high, especially with Russia cancelling imports of Nitrate Ammonium (one of the components of fertilizer) for 2 months until April 2. Considering the high Producer Price Index (PPI), the strong momentum in processed food and coming wage inflation, we consider inflation risk to be skewed to the upside.
For 2023, we expect core and headline inflation to significantly decrease to 1.7% on average, but again, uncertainties remain high. The evolution of supply disruptions, wage dynamics and energy prices will be of utmost importance.
Whatever inflation expectations may be for 2023, current massive inflation numbers and high energy prices point to a significant risk of much higher inflation forecasts by the ECB in March, especially the ones for 2022. The two-year horizon (2024) might dangerously approach the 2% level, which could lead to a more hawkish outlook. Inflation will put pressure on the ECB to maintain a relatively hawkish tone during most of 2022, which is negative for market sentiment.
On the US side, we also expect inflation to remain very high in the coming months. We expect 2022 inflation to average 5.7% and core inflation to average around 5%. The evolution throughout the year will be comparable to what we expect in Europe with very high inflation until the end of April (above 7 %) and a slowdown until the end of the year. We expect headline and core inflation to end the year around 3.5%, above the FED’s objective.
Home prices have a significant influence on owner’s equivalent rent (OER) and rent components, which overall account for 40% of core inflation. With regards to rents, several indices (REIS rents, Zillow rents) suggest that the current acceleration in rent inflation could continue well into 2022, taking the YoY pace of above 5% in S2 2022 and 2023.
Wages are also an important determinant for the medium-term inflation perspective (especially in services). Over the last six months, the Atlanta FED wage tracker has accelerated to 4.5% YoY, a 20-year high. The near-term outlook remains uncertain: the job quits rate in the private sector suggests further acceleration in wages, while the Conference Board’s expectations index, based on consumers’ short-term outlook for income, business and labour market conditions, suggests that a decline is coming.
Contrary to Europe, we expect high core US inflation, even in 2023, mainly because of high core inflation in the service sectors (high OER and rent components). We expect inflation to come out lower than in 2022 but to average around 2.8% in 2023, above the FED’s target rate.
High inflation figures in the coming months will support a relatively hawkish tone from the Fed, which is again negative for market sentiment.
Personal consumption has been very high in the US in 2021 thanks to strong fiscal support that is now slowly fading. Historically in the US, there is a negative correlation between inflation and personal expenditures and if this relationship stands here again, we must expect consumption to slow down over the coming quarters. Consequently, US growth could disappoint towards the second part of the year even if inflation is still high.
Potential slowing growth, high inflation and central bank tightening… this is not the best environment for risk sentiment overall.