Too much or too little?
If we are to believe central bankers in the West, inflation is on track for the 2% target. For this reason, the US Federal Reserve (Fed) thought it appropriate to reduce its key rate by 50 basis points – a move of a size rarely seen outside of recession – on 18 September. The European Central Bank (ECB) has done the same in two steps and is getting ready to go further.
However, projections for inflation have recently risen again, at least in the US. The inflation level expected in one year’s time on the other side of the Atlantic, as reflected in the one-year zero-coupon inflation swap rate, has moved from 1.70% on 6 September to 2.3% on 25 October. As a consequence, long rates in the US have tightened significantly, from 3.6% on 16 September to 4.2% on 25 October. They are still higher than at the beginning of the year, despite the assumption that inflation has been beaten.
In contrast, expectations in Europe have barely changed, so it also follows that long rates have proven stable over the same period, moving only slightly from 2.1% to 2.3%. And the euro has lost 2.8% against the dollar, reflecting the growing spread in interest rates between the two regions.
Whilst such changes are not alarming per se, they nonetheless highlight somewhat concerning developments. In the first instance, although it is not a done deal, they reflect growing expectations in the market of a Trump victory, in line with changes in opinion polls in the swing states where the US presidential election will be won. Trump’s policies are considered inflationary and, in principle, negative for European exporters for a number of reasons: customs duties on imports, not just from China but from across the world; an ultra-expansionary fiscal policy that is unsustainable and therefore a source of overall financial instability; and a much tougher stance on immigration which could result in the deportation of millions of migrant workers. Deporting these workers or, at the very least, stemming the flow of new arrivals, would certainly directly support the hourly wage for the least qualified workers by reducing the potential labour pool. This would be positive for the workers who remain. But this would also subsequently help support overall inflation and therefore interest rates, which could ultimately prove far less favourable for the same category of workers. This impact of immigration policies on the economy implicitly illustrates how positive the massive immigration seen in the US since 2021 has been. According to the nonpartisan Congressional Budget Office, the wave of immigration has provided a significant stimulus to US GDP, whilst holding down wages inflation – and therefore overall inflation[1]. An abrupt shift could slow growth in the world’s largest economy, and delay inflation reaching the desired level.
In the second instance, the recent change in rates is indicative of the doldrums in which the European economy finds itself. Whilst the US has remained surprisingly strong this year – despite fleeting doubts in August – Europe’s performance has been notably sluggish, and its fall in inflation surprisingly swift. Some monetary policy makers at the ECB are even reported to be considering the need for a new wave of expansionary policies with key rates moving below 2%[2]. The spectre of too-low inflation, typical of the 2010s, is returning to haunt European central bankers.
The developed world is becoming even more fractured: on the US side, the return of slightly surplus inflation is feared, or occasionally hoped for as a means of mopping up impressive levels of public debt; on the European side, inflation could prove anaemic, which will do nothing to help get public debt under control. Too much or too little – there are excesses and divides evident in the global economy, and yet it continues to turn.
Disclaimer: The opinions cited are those of the fund manager. LFDE shall not be held liable for these opinions.
Final version of 25 October 2024, by Alexis Bienvenu, Fund Manager, LFDE