Headline CPI disinflation is set to slow in the next months, but services inflation will be its biggest obstacle as it comes down at an even slower pace, or even accelerates, according to the Swiss Re Institute.
“Despite rapid interest rate rises over the past year, central banks are still far from meeting their inflation targets. We see persistent price pressures precluding rate cuts this year, with services inflation the biggest obstacle to disinflation,” said analysts.
Adding: “The hard market in insurance will likely continue as claims costs also remain elevated; a volatile yield environment will need discipline in balance sheet management.”
The global outlook for disinflation depends primarily on the services sector the Institute highlighted.This will impact personal lines insurers on account of high bodily injury claims.
In the US, core CPI goods inflation peaked at 12.4% in February 2022 and has since eased to 2.1% in April 2023. While the disinflationary impact from supply chain improvements and base effects will fade and goods inflation may reaccelerate, core goods make up just 21% of the US CPI basket compared to core services’ 58% share.
Analysts expect US core services inflation will cool from 6.8% currently to a still high 5.2% by year-end, contributing 3.0 percentage points (ppt) to headline inflation alone.
They noted that the bulk of services disinflation will be driven by lagging shelter prices, but price pressures in non-housing segments are unlikely to abate sustainably until wage growth eases from its current 5% pace to the 3.5% y/y rate consistent with 2% inflation.
In the euro area, analysts expect the disinflationary path of core measures to prove more shallow. Tight labour markets are underpinning worker and union bargaining power but unlike in the US, wage contracts are settled as multi-year agreements, meaning that the catch-up in real wages lasts longer.
Public sector pay settlements can set a high benchmark for subsequent wage negotiations in other sectors (eg in Germany, where part of the public sector negotiated a 5.5% increase after striking).
According to the report, this sets the stage for a prolonged disinflation simultaneously risking a de-anchoring of inflation expectations.
Other central banks offer a template for how too-slow disinflation from too-high inflation means a rate “pause” may just be a “skip”, analysts noted.
The report said: “The Reserve Bank of Australia (RBA) paused in April after increasing its policy rate at its previous 10 meetings. But it surprised markets by resuming tightening with 25 bp increases in both May and June, citing persistent services price inflation and an uptick in house prices.
“Wage growth has started to accelerate, suggesting a “kinked” Phillips curve at record-low jobless rates. In June, RBA Governor Lowe acknowledged that inflation has peaked but that further tightening is still needed to send a signal that interest rates will be high enough for long enough to prevent price pressures from building again.”
In early June, The Bank of Canada did the same, it raised its policy rate by 25 bp after two consecutive skips, expressing concern that CPI inflation could get stuck above the 2% target, the report highlighted.
Analysts stated that the disinflation path is quicker than the 1970s inflation burst, which was accompanied by a wage-price spiral. Supply-side shocks (mainly commodities), the major cause of inflation today, typically have asymmetric pass-through: faster and more complete on the way up than on the way down.
However, given ongoing labour market tightness and late-cycle catch up in real wage growth, the current cycle is different, the report highlighted. Both are underpinning ongoing strengthen in aggregate demand.
“How persistent inflation will remain is uncertain. But the risk that it could be longer lasting is one reason why we do not expect the Fed or European Central Bank (ECB) to begin cutting interest rates until 1Q24 at the earliest (the speed and magnitude of cuts is also highly uncertain),” analysts concluded.
Adding: “In our baseline scenario, a US recession in 2H23 will not prove severe enough to trigger outright deflation, suggesting policy rates may need to ease only gradually to ensure that disinflation pressures persist long enough to reach central bank targets.
“We see the balance of risks skewed slightly higher for the ECB: the question is less directional but by how much higher rates will go. For insurers, higher rates support investment returns, although what could be volatile yield environment will require careful balance sheet management.”
