Sandrine Soubeyran
- Tight labour markets make reducing inflation a challenge for central banks.
- Goods inflation has collapsed, after demand switched to services after Covid, helped by near full employment.
- The bear inversion of the yield curve has prevailed in 2023, and into 2024 – often a signal of a recession, and in contrast to expectations of a gentler, soft (economic) landing.
What are the current challenges for central banks in trying to reduce inflation?
Fighting inflation has dominated G7 central bank agendas in 2023 and continues into 2024, as central banks – with explicit targets – have tried to return inflation towards 2%. Despite most major economies generally avoiding a full-blown recession, tight labour markets, declining savings ratios, and higher energy prices have made this effort challenging, with “easy” disinflation gains now complete.
Tight labour markets and sticky core inflation in services proved the biggest challenge for central bank inflation control. This phenomenon is evident in most G7 economies, where labour markets have remained tight due to shortages, and are close to historic lows, though this appears to be easing more recently. In the US, the unemployment level had stayed unchanged at 3.7% since November 2023, but rose a little to 3.9% in February 2024. The soft landing in the labour market, at near full employment, with wage growth high, despite stabilising, helps explain the US Federal Reserve (Fed) policy pause since Q4 (i.e., its decision to maintain rates ‘higher-for-longer’) and more recently, caution on early pivots.
Similar to the US, UK wage inflation remains high, despite easing at 6.2% year-on-year in Q4, and headline inflation falling to 4.0% year-on-year in January. Unemployment has also been low, after being revised down by the UK’s Office for National Statistics (ONS) to 3.8% in December. High wage inflation continues to drive higher UK services inflation.
In the Eurozone, wages have been growing by about 5.0% on average, underpinning continued high demand for services and creating a risk of second-round inflation effects, if wage bargaining adapts further to higher inflation rates. This has been propping up services inflation, which despite being lower at 4.0%, remains close to its peak of 5.5%.
Most of the G7 countries, including the Eurozone (see chart), has seen goods inflation collapsing, as demand switched to services and manufacturing activity contracted, with related declines in industrial production, investment and international trade in goods.
Goods and services inflation (%)
Source: Eurostat and LSEG, February 2024. Data as of September 30, 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures
Higher energy prices since January, due to supply cuts and mounting geopolitical risks, have also hampered central banks’ efforts.
As a result, most G7 central banks still caution of early pivots and do not expect to meet their inflation targets before 2025.
What is the data telling us about the current inverted yield curve?
As shown in the chart below, the bear inversion of the yield curve prevailed in 2023, and into 2024, as short-term government bond yields have been higher than their longer-dated equivalents – often a signal of a recession, and in contrast to expectations of a gentler, soft (economic) landing. A soft landing would imply a very mild, or no recession, and a return to growth.
Japan remains the exception, with its yield curve constrained by the Bank of Japan’s yield curve control policy, despite some speculation of a change in monetary policy.
Slope of G7 yield curves
Source: FTSE Russell as at February 29, 2024. Data as of September 30, 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures
In a higher yield world, income and carry optimisation may supplant duration as key factors.
Sandrine Soubeyran
Yields have adjusted to the notion of higher-for-longer rates – a reversal from the move seen in the summer and in Q4 2024, when the peak in interest rate rises appeared close and G7 government bond yield curves disinverted, as a result.
Who is feeling the pain the most from the bond-market sell-off?
Investors needing to hold long duration bonds (such as asset owners, like pension funds) would have incurred negative returns since January 2024, as discussed in our Fixed Income Insight Reports (Fixed Income Insights | LSEG). Like for much of 2022-2023, duration has been investors’ enemy, with the long end repricing to higher policy rates for longer. In a higher yield world, income and carry optimisation may supplant duration as key factors.
Duration have been investors enemy in 2023, like in 2022…
Sandrine Soubeyran
Q: Are we looking at a higher for longer scenario in terms of interest rates?
Although central banks, globally, were successful in reducing headline inflation in 2023, inflation remains above target in most jurisdictions with evidence of labour shortages, and hoarding, and wage bargaining adapting to higher inflation rates.Therefore, market fears of a ‘higher-for-longer’ policy rate scenario in global government bond markets has become the dominant narrative, as 10-year yields rise to new highs, especially since the recent Middle East turmoil.
And, even if lower housing costs have kept US CPI inflation below 4% year-on-year, the Fed remains concerned about the current strength in the US economy and tight labour markets.
Q: Can you explain what’s behind the Global Investment Research?
The Global Investment Research team – or the GIR team as it is commonly known – is a client-facing research group, helping clients navigate financial markets. We publish insights on current market dynamics across regions and asset classes.
Our research, by way of monthly and quarterly reports, topical commentaries and deep-dive empirical research, and our presentations to clients and the investment world, contribute to research discussions in the investment community, and improve our engagement.
These are all freely available on the FTSE Russell website. For more information, please visit our research hub on Market Insights | LSEG and/or register to receive it directly in your inbox.
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