Investors may still be underestimating how inflation is cooling

The writer is head of macro research at BNP Paribas Asset Management

Inflation remains the number one topic for investors. Understanding what is happening to inflation is the key to forecasting what central banks will do, and hence how bonds and equities will perform. But we do not all look at inflation in the same way and right now that makes a big difference to the conclusions drawn about the economy, monetary policy and markets.

National statisticians publish data on consumer prices at a monthly frequency. That much is common. In Europe, when we talk about inflation, we compare how prices have changed over the past year, and for a very simple reason. Many prices exhibit a clear seasonal pattern which can obscure the underlying rate of inflation that we are interested in. It does not make much sense to say we start each year in deflation just because there are always sales after Christmas and the prices of many items tend to fall between December and January.

Comparisons against a year ago circumvent this problem. However, they do so at a cost. Macroeconomic circumstances can change over the course of the year, and hence so too can the underlying rate of inflation. The change on a year ago measure will inevitably be slow to capture a sudden, significant change in that underlying trend.

They do things differently in the US. The statisticians estimate and then remove the seasonal trend from the data. Now we can track the underlying rate of change of prices from one month to the next. We can assess whether prices are consistently rising too fast each month or not — or, in the jargon, whether high inflation is proving persistent.

We could do the same in Europe. Seasonal adjustment can be as simple as a click of a button in a software package. The European Central Bank publishes seasonally adjusted data for those who do not want to get their hands dirty.

Nevertheless, the focus in Europe remains on how unadjusted prices have changed over the past year. From this perspective, inflation is falling but is still too high. No surprise then that many commentators insist that interest rates must stay high to squeeze inflation out of the system.

You get a completely different impression if you focus on the recent trend in the seasonally adjusted data. The pace of disinflation is more dramatic, and the current rate of inflation looks far less worrisome. Indeed, the ECB data suggest that core inflation turned negative in the eurozone in the last month for which we have data. Even if the latest data turns out to be erratically weak, the trend is clear. 

It is a similar story in the UK. Prices are rising at a much more manageable rate from one month to the next, but the punchy pace of increases earlier in the year means that the change on a year ago measure is still elevated. Core consumer prices were up 5.1 per cent on a year ago in November, well below consensus forecasts. More importantly, seasonally adjusted core prices were essentially flat on a month ago

We have a similar story with wages. The Bank of England’s favourite measure of private sector pay was increasing at an extremely rapid rate in the spring. Wages are up a lot relative to where they were a year ago. But the rate at which wages are rising from one month to the next has slowed dramatically since the spring. In fact, pay actually fell in the last month for which we have data. Again, that could be noise, but the signal is clear.  

It is not hard then to understand why investors are increasingly confident that the hiking cycle is complete and rate cuts are coming soon. Prices are a lot higher than where they were a year ago. But the period of rapidly rising prices is retreating in the rear-view mirror. Inflation has not proved persistent. 

On the contrary, underlying inflation has cooled significantly in recent months. If you look at how wages and prices have changed over the past month, rather than over the past year, you will conclude that the inflation genie is already back in the bottle.

It would take a brave economist to rule out the possibility of a reacceleration in wages and prices after the chastening experience of recent years. However, a significant and sustained pick up looks less likely now. 

For now, interest rates will seemingly stay high as an insurance against that possibility. But with interest rates in restrictive territory, the question is increasingly whether the underlying trend in inflation will continue to cool in the coming months. It is not impossible that inflation will soon be too low for comfort. In that case, investors are still underestimating how many rate cuts are coming.