Are central bank rate hikes finally working?

The big news on Thursday is that European inflation is falling at a rapid pace. Spanish inflation halved in March, compared with expectations. Spanish headline price growth fell to 3.1%, down from 6% in February, and the weakest level since August 2021. Analysts had expected a 3.8% rate. This is within touching distance of the ECB’s target rate of 2%, and the decline was largely due to sharp falls in electricity and fuel prices. However, as we have said in recent months, 2022 was all about headline inflation, 2023 is all about core inflation, and the picture is murkier once you strip out food and energy prices.

Spanish price growth lower, but core is still a problem

Core price growth is where the ECB is looking, and the picture is less rosy for Spain and other countries in the Eurozone. In Spain, core prices are still running at a 7.5% annual rate, down a notch from the 7.6% annual rate recorded in February. This is way above the 2% target rate and suggests that embedded or sticky inflation is still a problem for the Eurozone. Spain is considered a bellwether for Eurozone prices, hence why it is a closely watched index. It led inflation higher in the currency bloc, thus it could also be a lead indicator that headline inflation in the currency bloc will decline in the coming months. German inflation was also released on Thursday, and it showed that inflation slowed, but at a slower pace than expected. Even with steep fuel price declines, German headline inflation still rose by a hefty 0.8% in March, on the back of food price increases. In Spain, some of the increase in food prices were mitigated this month due to the Spanish government cutting VAT for essential food stuffs including bread, milk, cheese and fruit and vegetables. VAT was cut from 4% to 0% to ease the cost-of-living crisis. Thus, the decline in headline inflation in Spain was not all down to global trends for lower commodity prices.

Profit-led inflation, the biggest threat to economic growth

Looking ahead, Spain’s inflation data highlights the prospect of volatility in the monthly inflation figures going forward. We expect this to also be replicated in the UK, after a surprise jump in prices in February due to shortages of certain vegetables, which caused price increases. UBS economists have made a pertinent argument about inflation trends, the rise of “greedflation” or “excuseflation”. This happens when profit-led inflation is not caused by a demand surge or a supply shortage. Instead, UBS argue that profit-led inflation happens when companies, or individuals spin a “fairy-tale to persuade people that profit margin expansion is fair”. UBS analysis has found that this happens in both large companies and in smaller companies. Not every sector will do this, they need to have stable demand and a scapegoat, which is why it happens so frequently in the food sector, UBS analysts explain. They argue that therefore the cost of a pint of milk in the UK has exploded, along with the price of eggs. Their suggestion for stopping profit-led inflation in its tracks: stop consumers believing that the increases are justified, use social media to get this message across, post one-star reviews of rip-off items and outright boycotts.

It seems unlikely that there will be outright boycotts of milk or eggs; however, if this story gets more traction, then it could make shop owners, supermarkets or one-man bands taking the biscuit when it comes to expanding their profit margins. Interestingly, UBS argue that interest rate rises can temper some of the profit-led inflation that it has described, but not all. They also think that this is an unnecessarily destructive way to reduce it. Instead, the name and shame approach could work better, in their view. This is an interesting angle, and one that central bankers may want to take on board the next time they speak in public. If they mention it, then it could gain traction and limit some of the profit-led inflation that is increasing price pressures in the economy.

The Fed vs the market: will rate cuts materialise?

US PCE data was also released on Thursday, this is a closely watched inflation gauge, as it is the preferred measure of inflation for the Fed. Quarterly PCE growth was 3.7% for Q4, in line with expectations, however, core PCE ticked up slightly at 4.4%, after reaching 4.3% in Q3. This is a backward-looking index, but it does highlight how core inflation, and service sector inflation, is difficult to lower through interest rates alone.  Added to this, although jobless claims in the US ticked up last week to 1.689 million, they remain at historically low levels and show that the labour market remains extremely tight. This could keep pressure on the Fed to ensure that even if we are close to the peak in interest rates, they may remain higher for longer, with some analysts questioning if the market is correct to price in multiple rate cuts for the second half of this year.

BOE needs to tread carefully

In the UK, money supply has fallen for February, M4 was down 0.4% on the month, with weaker consumer credit growth and net lending to individuals, which was £2.2bn in Feb, down from £3.7bn in January. This is worth watching, since net lending fell sharply in the UK before the recent bout of banking turmoil, which is expected to trigger even more credit tightening/ lower demand for credit in the coming months. Net lending has been falling since July last year, as higher interest rates take their toll. However, there are a few worrying consequences from this decline in lending: 1, the UK’s reliance on the service sector for growth, and 2, the fact that the savings rate is falling. Thus, once savings have all been used up, will growth take a hit? This is a big risk for the UK economy and is why the BOE needs to tread carefully at this stage of its monetary policy cycle.

Risk sentiment remains buoyant for now

The market has been in an upbeat mood so far this week, with the S&P 500 clearing the 4,000 resistance level. The Nasdaq is up nearly 14% so far this year, who said that tech is dead? As we have said throughout 2023, it is easy to be a bear and spin a bearish narrative, it is harder to be invested, however, it is much more rewarding. While being a stock picker has worked this year, it can’t be denied that indices have also had a decent performance, especially with the ongoing interest rate increases and the recent stress in the financial sector. As we move into Easter week, momentum remains strong, and we may see quiet markets. There is also no known risk that could hurt markets in the short term, however, always be careful of unknown unknowns, especially in this environment. In the FX space, the dollar is declining, and the EUR is the big winner on Thursday. EUR/USD is trading above $1.09, the next test for this pair is $1.10. Weaker headline inflation did not weigh on the single currency, as the market is focussed on the prospect of a hawkish ECB to combat core inflation, which remains elevated. The dollar is also falling, even though the 2-year Treasury yield is back above 4% and has risen 9 basis points on Thursday. As risk sentiment improves, the 2-year US Treasury yield is rising, and returning to more normal levels. It is worth noting that 1, strong economic data and 2, improving risk sentiment could lead to shifts in market expectations for the Fed Funds Rate, with fewer rate cuts expected for the US economy. Ironically, when or if this happens, that is when risk sentiment could take a knock and the recent rally for stocks takes a pause.