The rigidity of prices in a range of products and services, both in the Eurozone and in the US, seems to be delaying the completion of the upward cycle of interest rates and the beginning of their downward cycle, as can be seen from the meetings held during the week by the European Central Bank and the Federal Reserve Bank (Fed).
The main reason is common for both central banks: Structural inflation, which excludes volatile energy and food prices and is therefore a better proxy for monetary policy, is falling much less than monetary authorities expect.
In the US, headline inflation peaked last year in September at 6.3% and in the eight months to May fell just one percentage point to 5.3%, while the headline index fell from a high of 9.1% last June to 4% in last month. Fed Chairman Jerome Powell on Wednesday justified the central bank’s decision to leave the key rate unchanged but signal a possible further hike of half a percentage point to 5.6% by the end of 2023, with the very slow deceleration of structural inflation.
In the Eurozone, headline inflation rose steadily until March and in April-May fell by four-tenths of a percentage point to 5.3% year-on-year, while headline inflation peaked at 10.6% last October and fell to 6.1% in May, thanks mainly to lower energy prices.
On Thursday, the ECB, as expected, raised its key interest rates by a quarter of a percentage point – with the deposit rate set at 3.5% – and its president, Christine Lagarde, announced a corresponding increase in July, not ruling out to have another such move in September. Lagarde spoke of a disappointing outlook for structural inflation as the ECB staff’s new forecast has been revised upwards to 5.1% in 2023 from 4.6% three months ago.
But why aren’t prices deescalating as predicted? The explanation also appears to be broadly shared on both sides of the Atlantic: Economic activity and the labor market are much more resistant to interest rate increases and thus sustain a level of aggregate demand that is incompatible with a faster decline in inflation.
In the US, Fed officials’ average forecast for GDP growth this year was revised upwards to 1% from just 0.4% in March, while the unemployment forecast was revised down to just 4.1% at the end of year on year from 4.5% in March as businesses continue to hire and overall employment increases. With these data, there is not a large reduction in demand that would allow for a reduction in prices. On the contrary, many companies are facilitated in a policy of increasing their prices at a rate faster than the increase of their operating costs, including of course the increase of wages.
With energy and other commodity prices falling significantly this year – the ECB estimates the average decline in non-energy commodities to be 11.5% in dollar terms – it is clear that many businesses are increasing their profit margins by taking advantage of the general inflationary background. The fact that companies can increase their profit margins also explains why they do not reduce their employment.
Something similar applies to the Eurozone. Unemployment is at historically low levels and is forecast to reach 6.5% for the whole of 2023 compared to the 6.6% that was forecast by the ECB in March, while employment is forecast to increase by 1.3% compared to a forecast of 0.8 %. Lagarde said the risks to inflation are also on the upside due to the expected increase in wages to cover some of the loss of their purchasing power, while the Eurozone is also seeing the phenomenon of increasing profit margins from businesses.
Source: RES-MPE
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