As markets eye rate cuts, JP Morgan declares the inflation fight is not over

While markets are eyeing rate cuts, JP Morgan says central banks in the US and Europe will not ease monetary policy as much as expected in the first half of 2024.

Hopes of rate cuts abound, but JPMorgan says central banks in the US and Europe won’t ease monetary policy as much as expected in the first half of 2024 as disinflation progress stalls.

With markets recently expecting about 100 basis points of rate cuts by the US Federal Reserve and European Central Bank in the first half of the year, waning optimism on rate cuts could check the recent rally in stocks and bonds.

Minutes from the December Fed meeting confirmed that policymakers thought the Fed funds rate was “at or near its peak for this tightening cycle”. However, that wasn’t enough for markets, which expect the US central bank to begin rapid-fire interest rate cuts in March.

US tech stocks suffered their longest daily losing streak in a year as the US 10-year bond yield rebounded from 3.8 per cent to 4 per cent, after its recent retreat from a 16-year high of 5 per cent.

The ASX 200 index fell 1.3 per cent, in its worst week in more than two months.

That followed a 13 per cent rise in the past two months to a near-record high of 7627.8 points.

US jobs data overnight on Friday were expected to show resilient jobs growth, a slightly higher unemployment rate and the smallest growth in average hourly earnings since mid-2021, supporting expectations that US inflation would hit target levels within two years without a significant cost to economic output.

But could the market now be a bit too optimistic about the inflation outlook?

After two years of 5 per cent annual growth rates, global core inflation fell to 3.3 per cent in the second half of 2023. Markets are pricing a near complete return of inflation to target in the US and western Europe over the next two years, a view fuelled by a shift in central bank guidance.

The latest interest rate projections from Fed officials saw US ­inflation returning to target over 2024-25, along with trend economic growth, stable unemployment and 200 basis points of rate cuts.

The sharp and broadbased slide in core inflation in the second half of 2023 signalled that much of the post-pandemic inflation spike was caused by supply-side shocks from the pandemic and the Ukraine war. That faded rapidly last year.

But it would be a mistake to see this dynamic – which has pushed global core CPI inflation down nearly two percentage points over the past two quarters – as likely to generate a substantial additional inflation slide in the first half of this year, according to JPMorgan chief economist Bruce Kasman.

He sees the recent fall in goods prices as “transitory”, as downward pressure on goods demand and input costs is fading and services price growth looks supported by labour costs and demand growth.

JP Morgan chief economist Bruce Kasman. Picture: Bloomberg

JPMorgan expects core global inflation to settle near 3 per cent in the first half amid a rebound in goods inflation and sticky services inflation.

If so, markets may again question if a “soft landing” amid “immaculate disinflation” is likely.

Mr Kasman says goods price deflation has been the main cause of disinflation so far, with global goods prices falling at an annualised rate of 1 per cent in the three months to November.

But global supply chain pressure indicators have rebounded, with a notable turn up in both air and shipping freight costs in recent months, according to the New York Fed’s Global Supply Chain Pressure Index.

Alongside this move, the disinflationary impulse from a full year’s contraction in manufacturing looks to be abating, as global factory output returned to growth in the second half of last year.

Global services price inflation also moved lower in the second half, but in recent months core services inflation has moved sideways at an annualised pace of about 4.5 per cent.

In contrast to the goods sector, service-sector demand growth remained strong over the past year and the unwinding of dislocations that have tightened labour markets and pushed wage inflation higher hasn’t normalised, according to Mr Kasman.

Against this backdrop, he sees only a moderate slowing in service price inflation to a 4 per cent annualised rate in the first half of 2024. A lift in core goods price inflation to a 0.8 per cent annualised rate is expected to keep global core inflation at about 3 per cent.

Complicating the outlook have been significant downside surprises in euro area inflation and US core private consumption expenditure (PCE) inflation in ­recent months.

But Mr Kasman says the recent slide in euro area service price inflation reflects technical distortions that are set to unwind this quarter. For the US, he says a difference in the treatment of shelter prices explains part of the gap between core PCE and core CPI inflation, and the former has also been depressed by non-market prices, which “more likely represents noise than signal”.

An expected stalling in the pace of disinflation in the first half doesn’t diminish the importance of the unwinding of most of the 2021-23 inflation spike. “It increases the odds of a shift to less restrictive monetary policy stances later this year,” Mr Kasman says.

“Alongside recent growth resilience and easier financial conditions, the prospect of central bank easing in the first half has raised our assessment of the probability of soft-landing outcome to roughly equal to a ‘boil the frog’ outcome in which sustained restrictive policy stances gradually undermine private sector health.

“That said, a forecast of firming core goods and sticky service price inflation will likely limit the size of first-half easing relative to current market pricing, absent a more tangible threat to growth.”