Higher oil prices has disturbed the previously benign inflation picture in the US. What are the implications and could it have a knock-on effect in the UK and Eurozone?
- Rising petrol prices pushed the US CPI to 3.7% in August, up from 3.2% in July
- Core inflation continues to fall, and the move is unlikely to change the Fed’s current position
- The UK and Eurozone are on a different path and may cut rates sooner
The latest US CPI data is a stark reminder that inflation is not yet beaten. Rising petrol prices were the key factor in pushing inflation to an annualised rate of 3.7%, up from 3.2% in July. While this rise was largely expected – and financial markets absorbed it without any drama – it does suggest that the Federal Reserve’s decision-making could be more complex at its next meeting.
Importantly, core inflation, which excludes volatile energy and food prices, continued to fall. The Federal Reserve has previously said that it is prepared to look through short-term energy spikes in setting rates. As a result, markets have concluded that this data is unlikely to change the Federal Reserve’s position on its own.
Nevertheless, if the economy is still strong and inflation appears untamed, it seems vanishingly unlikely that the Federal Reserve will cut rates next year. A fall in borrowing costs is still expected by markets by mid-2024 and as the economy powers ahead and commodity prices rise, that looks too optimistic. Higher for longer is now the more realistic scenario.
That said, investors should be careful of extrapolating the situation in the US to other countries. In the UK, the latest GDP data shows that there are real structural weaknesses in the UK economy. Problems are starting to be felt in labour markets, in spite of recent wage rises. The economy is far more sensitive to interest rates than the US and inflation has been higher for longer. The burden on households is significant.
The Bank of England recognises the danger of pushing interest rates higher, causing an abrupt slowdown in the UK economy. The UK still looks more vulnerable to recession than any other major developed markets. Bank of England governor Andrew Bailey recently said that rate rises were drawing to an end. Lacking the fiscal flexibility to boost growth, the BofE may drop rates far sooner to ease pressure on the economy.
Europe’s growth engine, Germany, is also flagging, with weakness in its dominant manufacturing sector. The region is currently relying on strong tourism in Southern Europe to support growth, but this strength will need to diversify if it is to avoid recession. Either way, the ECB may have one more rate rise ahead and then may also start to cut sooner than the US.
While it would have been reassuring if the US CPI data had shown a gently falling path, this is perhaps unrealistic and should not yet be a source of significant concern. It may mean US rates will fall slower than expected, but the UK and Eurozone remain on a different path.
