Chairman’s Views

North Atlantic Drift

As at 19 July 2023

Author: Gavyn Davies, Chairman

Main Points:

  • There are increasingly convincing signs of declining headline and core inflation in the US, while the labour market remains very robust and recession risks appear to be falling further.
  • Markets have begun to interpret these data releases as indicative that a soft landing is now the most likely outcome for the economy in the next 12 months. This interpretation seems justified for now.
  • A US soft landing would tend to reduce risk premia in global asset prices, which would support equity prices, reduce credit spreads, and encourage a depreciation of the dollar, notably against emerging market currencies. Although these trends have been in place for a while, the recent reduction in US recession risks could result in further moves in the same direction.
  • US bond yields may also start to fall if a soft landing is confirmed. However, as explained here last week, the sharply inverted yield curve in the Treasuries market will act as a constraint on long duration government bonds until the Fed indicates that policy rates have definitely peaked. We do not expect this to occur until core inflation is much closer to the 2% inflation target. We continue to favour short duration bonds over long duration.
  • Most other asset markets in advanced and (especially) emerging economies would benefit from reduced risk premia under a soft-landing scenario for the US. Normally, this would certainly include UK assets. However, at present, inflation risks in the UK appear to have moved in entirely the opposite direction from the US, raising idiosyncratic risk in British assets.
  • The Bank of England has fallen far behind the Fed and the European Central Bank (ECB) in addressing inflation risks, which are greater in the UK in any event. Despite better inflation data in June, the Bank now needs to act fast to address this problem, thus raising hard landing risks.


US Soft Landing?

1. Last week, we noted that FOMC members, including Chairman Powell, had reacted to incoming employment and wages data by strengthening their language on forthcoming monetary tightening. This had caused a sharp sell-off in US and global bond markets, taking 10-year nominal yields on treasuries to above 4%. Since then, there has been little or no softening in Fed guidance, but bond markets have eliminated much of the sell-off which occurred in early July. The trigger for this reversal was the publication of much lower core and headline inflation in the US CPI release for June. This has raised doubts about whether the Fed will need to deliver the rate hikes discussed recently, leading to a further shift towards a soft landing in market pricing. An indicator of the change in market mood is that Goldman Sachs Chief Economist Jan Hatzius has recently reduced his estimated risk of recession to only 20% in the next 12 months¹.


2. Core CPI came in at 0.158% in June, ending a 6-month series of reported increases of around 0.4% per month. The key question for the FOMC on 26 July is whether this single monthly improvement is enough to soften their language, thus encouraging the markets to believe that the July rate increase could be the last in this cycle.


3. The good news is that the June release showed significant improvements in most categories of inflation. Core goods prices actually declined by -0.05% as used car prices subsided sharply. Core services ex shelter (ie Chair Powell’s so-called “favourite” measure) increased by only 0.09%, and there were finally signs that housing inflation is now moderating somewhat. Although there were concerns that the declines in hotel prices (-2.0%) and airfares (-8.1%) were aberrational, most of the regional Fed measures of underlying inflation are now declining markedly.


4. Figure 1 shows the latest Fulcrum estimates for “underlying” headline and core CPI inflation. (These concepts can be viewed as similar to the Cleveland Fed “nowcasts” for the relevant definitions of CPI inflation, though the Fulcrum measures are certainly not identical.)² The June CPI data release caused a drop of around half a percentage point in the underlying core inflation rate on Fulcrum’s measure, following a drop of equivalent size when the May data were released. Interestingly, the combined drop of about 1 percentage point in underlying core inflation in May and June has almost exactly eliminated the sharp rise that occurred in February, when the Fed turned increasingly hawkish for a while.


5. The Fed does not produce official forecasts for the CPI definition of inflation, preferring to use the PCE definition that is published around two weeks later. The release for June is due to appear on 27 July, the day after the FOMC meeting. Figure 2 shows the Fulcrum estimates for underlying PCE inflation, prior to the June data release. Both measures of PCE inflation have been broadly flat this year, compared to the strong downtrends that have developed in the CPI series. The latest consensus forecast for the core PCE in June is for a rise of 0.2%, reducing the 12-month inflation rate to 4.1%. Although this is slightly better than the trends shown in the graph, the improvement is nowhere near as encouraging as the downtrend shown in the CPI series, albeit from higher levels at the inflation peak in 2022.


6. With CPI inflation falling sharply, but PCE inflation declining much more gradually, the FOMC is unlikely to change its broad guidance that two further rate rises (including the one likely to take effect in July) remain probable in the second half of 2023. However, Chair Powell is likely to leave some optionality for the FOMC to decide whether the next rate rise is necessary in September or November, or even whether it could be cancelled completely if underlying PCE inflation begins to decline more significantly.


7. Assuming that the Fed leaves its end-year guidance for the policy rate unchanged, though stated with more ambiguity than before, the market is likely to remain comfortable for now with its “one and done” interpretation of what the FOMC will deliver next week. This could result in further gains for the soft-landing trades that have now been working for some time in the US and global markets.


UK Hard Landing?

8. A major exception to the theme of soft-landing trades has been the UK, where monetary policy has not been hawkish enough to prevent further large rises in underlying inflation in recent months, in complete contrast to the general pattern of disinflation seen elsewhere in the advanced economies (AEs). Although the data for June represented a significant downside surprise for underlying headline and core inflation, both measures are still running at around 6%. Figure 3 shows the grizzly details.


9. Why has the UK proved to be such a clear exception to the general rule in other AEs this year? After all, the major supply side gains that have driven global markets – lower energy prices, improved supply chains and improved labour force activity rates – have applied to the UK as much as to other countries. There are three main factors that may have damaged the UK’s relative performance:

  • The history of UK inflation rates in the past 15 years shows repeated episodes where the 2% inflation target has been exceeded for lengthy periods, implying that inflation expectations are both higher and less well anchored on the central bank’s official target than in other AEs.
  • Although the Bank of England was the first of the major central banks to start raising policy rates in 2021, it has moved rates more gradually than the Fed and has never succeeded in shifting real policy rates into positive territory. Negative real rates have been insufficient to persuade the private sector that inflation will be brought rapidly under control.
  • A large part of the UK’s inflation problem has stemmed from rising goods prices, especially after the nation left the EU single market at the end of 2020. It is hard to avoid the suspicion that there has been an inflationary shock from the disruption to cross-border trading practices in the goods market that has acted like an increase in tariffs on imports of goods into the UK from the EU. If this has been the case, the Bank of England will face a challenging task determining whether to accommodate this shock in the form of higher inflation, and for how long.


10. In recent policy statements, the MPC has continued to predict that inflation will reach the 2% target by the end of 2024 but the market no longer believes that this will happen on the present policy settings. Instead, the market is pricing a further 100 bps of policy tightening by early 2024, by far the largest shift among the major central banks. So far, the expectation of this degree of tightening has been enough to drive the sterling exchange rate higher, implying that the market continues to believe that overall policy credibility in the UK will be maintained. However, such a large and belated monetary tightening shock could plausibly end in a hard landing risk to the economy, with much lower policy rates and a devalued currency during 2024. We will be watching carefully for signs that markets are beginning to price such an outcome into interest rates and currency valuations.

Figure 1 

Source: Fulcrum Asset Management

Figure 2 

Source: Fulcrum Asset Management

Figure 3 

Source: Fulcrum Asset Management

About the Author

Gavyn Davies

Gavyn Davies is Chairman and co-founder of Fulcrum Asset Management. Prior to Fulcrum, Gavyn was as an Economic Policy Adviser to the British Prime Minister (1976-1979) and a member of H.M.Treasury Independent Forecasting Panel (1992-1997). He was the Head of the Global Economics Department at Goldman Sachs from 1987-2001 and Chairman of the BBC from 2001-2004. Gavyn graduated in Economics from Cambridge followed by two years of research at Oxford and he is also a visiting fellow at Balliol College, Oxford.

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