A free hand but finger on the trigger
The continued decline in inflation is giving central bankers the freedom to act. We are on track and the 2% target seems well within reach in both the US and the eurozone. In August, year-on-year inflation was exactly 2% in Germany and 1.9% in France, but 2.2% for the eurozone as a whole. In the US, the PCE price index[1] – the Fed’s favourite measure – is indicating inflation of 2.5%. Granted, core inflation measures are a little higher, but the trend is similar. And Citigroup’s Inflation Surprise index is in negative territory, a sign that economists have been underestimating the speed of the fall for a number of months now.
As Fed Chair Jerome Powell confirmed at the Jackson Hole summit at the end of August, “the time has come for policy to adjust”. The Fed will therefore shift direction and introduce a phase of rate cuts at its next meeting on 18 September. But this statement is – certainly deliberately – ambivalent, since this policy adjustment also implies a shift in the Fed’s primary target.
The Fed’s mandate has three strands: stable prices, maximum employment and moderate long-term interest rates. The decline in inflation allows the Federal Reserve to focus on ensuring that the labour market remains sound from now on. And this is a very good thing, as weaknesses are starting to appear in the US. Job offers are drying up, the use of temporary labour is falling and youth unemployment is rising – tensions that had been bubbling under the surface are now fully visible. Unemployment was 4.3% in July meaning that the terms were met for what experts call the Sahm Rule: when the three-month moving average of the unemployment rate rises by 0.50 percentage points or more relative to the low for the previous 12 months – indicating that the US is in early recession. This rule has held for 80 years. The deterioration in the unemployment rate means that this threshold has been breached – a worrying development for the Fed and for markets, as witnessed by the turbulence seen in early August. Yet it is worth pointing out that the Sahm Rule is simply a statistic based on historic data that reflects rapid deterioration in the employment market. It is by no means a given that must hold forever. Furthermore, the inversion of the interest rate curve – also considered a precursor of recession – has been giving a false signal for the last two years.
Markets are thus entering a new phase where the strength of economic activity – and employment in particular – will take precedence. On the monetary policy front, the question is not, “when will the shift in policy come?”, but “how many cuts will there be?”. Central banks now have their finger on the trigger, it’s for investors to anticipate the rate of fire.
Final version of 30 August 2024 – Clément Inbona, Fund Manager, LFDE