Debates about the ‘last mile’ of bringing inflation back to 2% targets are raging across both sides of the Atlantic. Perspectives on the issue are one factor shaping expectations for the stance of monetary policy and central bank rate cuts.
Disinflation is present in the UK, euro area and the US, and progress has exceeded expectations. Energy prices have come down and their previous shock on economies has moderated. Supply chain pressures are easing. Central bank rate hikes have helped moderate demand pressures, to the extent these existed, cooling price increases.
Yet, services prices are not retreating as quickly as goods prices. Meanwhile, wage gains – largely due to catch-up from pandemic losses – are well above 2%. Many analysts and policy-makers are wondering if inflation will remain sticky at around 3%, making it hard to traverse the last mile to 2%.
‘Enduring persistence’ of inflation
Last week, Catherine Mann, external member of the Monetary Policy Committee at the Bank of England, joined OMFIF to discuss the difficulties of getting inflation back to target in the UK. Exploring a range of backward- and forward-looking indicators, she explained that current inflation forecasts ‘point to enduring persistence as well as upside risks to inflation.’
Her outlook was driven by the gap between goods and services inflation. Historically, the 2% headline inflation benchmark of the past several decades was composed of 0% core goods and 3.5% for services. While goods prices have been falling over the past several months due to easing supply side pressures, services inflation remains sticky. This is especially the case for consumer-facing services like dining, hospitality and entertainment.
The deceleration of goods price inflation is in line with target-consistent price dynamics. Meanwhile, the share of price increases ‘remains above the pre-Covid share and is thus not back to the pattern of services price increases, which, along with the goods price dynamics, did yield 2% inflation,’ Mann explained. Structural factors may now be changing that composition, and monetary policy needs to be carefully calibrated to reflect these trends.
Catherine Mann speaking at the OMFIF lecture
Drawing from consumer price index microdata and Decision Maker Panel firm surveys, evidence from firms’ pricing plans also indicate pricing asymmetries with upside inflationary risks. When a firm anticipates that its competitors will raise prices more quickly than it intends to, it will typically raise prices faster to match its competitors. However, this trend does not hold when expected price inflation for a firm is below its expected industry price inflation. ‘This kind of asymmetric pricing behaviour adds to persistence and may even yield an upward bias to inflation,’ Mann warned.
In an interview with the Financial Times, Isabel Schnabel – one of the European Central Bank’s most influential board members – echoed some of Mann’s concerns. ‘If you look at selling-price expectations in services, they have gone up for several months in a row. That’s why recent incoming data do not allay my concerns that the last mile may be the most difficult one’, she said.
Other ECB governing council officials are less worried about the inflation outlook. Banca d’Italia Governor Fabio Panetta highlighted in an interview that inflation is rapidly approaching the 2% target and it may soon be time to pivot to rate cuts. Banco de Portugal Governor Mário Centeno – who recently spoke at a roundtable with OMFIF members – published a paper in December 2023 that quelled some concerns over the tightness of the labour market. It noted that, ‘with today’s fundamentals and labour market institutions, the euro area will forgo wage-price spirals’.
The US is more sanguine, but no room yet for complacency
In the US, though the jury is still out, many now argue the move from 3% to 2% core personal consumption expenditures inflation can be smooth and concerns over the last mile – though still present – are easing. At the last Federal Reserve press conference, Chair Jerome Powell continually referenced 12-month inflation – core PCE is 3% on this basis. But he shied away from mentioning 6-month annualised data, which the Fed is known to keep a close eye on. On this basis in December, core PCE inflation had already reached its target. Further disinflation is widely expected in 2024.
Goods prices are running significantly negative but will flatten out according to Powell. Declines in shelter price growth have already been foreshadowed in private new rents, though other categories are less clear cut. Services and wage increases still give pause. Services inflation is easing but is around 5%. Closely related, wages are up 4.3% according to the employment cost index, but well down from the 5.5% mid-2022 peak.
The impact of wage gains on future unit labour costs and prices is difficult to assess – no wage-price spiral is evident, inflation expectations appear well anchored, cooling activity should curb firms’ ability to pass-through costs and productivity data are showing solid gains (at least at this moment).
On balance, in the US, any last mile may be run more quickly than across the pond. But there is no room for complacency and possible concerns about the last mile will provide a basis for caution on the start of rate cuts.
Deeper apprehensions in the UK and Europe about stickiness in services and wage prices are keeping a stronger focus on the last mile. In the US, those concerns are easing, though still present. These different viewpoints are likely to weigh on the timing of expected rate cuts. Mind the Transatlantic gap.
Taylor Pearce is Senior Economist, Nikhil Sanghani is Managing Director, Economic and Monetary Policy Institute, and Mark Sobel is US Chair, OMFIF.