Sticky inflation and stubborn central banks

Hello, I'm Vivian Estadt, Client Service Director at SEI. I'm here with Chief Market Strategist and Senior Portfolio Manager, Jim Solloway, who will provide a preview of some of the timely topics he covers in our most recent economic outlook. In the spring of 2021, you began to use the phrase "persistently transitory" to describe SEI's inflation view that inflation would stay higher for much longer than most anticipated. Now that we are in 2024, do you think the global economy has transitioned out of this inflationary phase?

That's right. As you said, we predicted inflation would be supported by COVID-19 stimulus packages, the associated shortage of goods and a developing structural labor shortage. Russia's invasion of Ukraine and prolonged COVID-19 lockdowns were unanticipated but further exacerbated the effects of inflation. Nevertheless, headline inflation has come down dramatically in the past year, raising hopes that the Federal Reserve and other major central banks are succeeding in bringing inflation back down to their 2% target without undue economic pain. As we see on the screen, on a harmonized consumer price index basis, US inflation was already near target as of this February with a year-over-year gain of 2.2%. At 2.6%, the Eurozone isn't too far away either. The improvement in the United Kingdom is coming along more slowly with the latest reading in February showing a 3.8% increase from a year earlier.

The 2% inflation target seems to be near and closer. Are you optimistic central banks can achieve this on a sustained basis?

We are still doubtful. The downward pressure on commodities and goods prices is already starting to ease as demand and supply come into better balance. The rapid deceleration in inflation caused by the outright decline in energy and other goods prices should itself be viewed as transitory, in SEI's opinion. We've said for several years that the effect of higher labor costs on inflation should not be ignored. Unit labor costs are a good yardstick of underlying inflation since they measure increases in total employee compensation, less productivity improvements. The chart on the screen highlights the rise in unit labor costs for the United Kingdom, Canada, the Eurozone, United States, and Japan for both 2023 and the 10 years prior to the onset of COVID-19. The comparisons are quite stunning as the increases in 2023 are quite hefty compared to the earlier 10-year periods. Although labor markets in the US and elsewhere are not as tight as they were a year or two ago, they are still tight enough to keep compensation growth at a pace that is significantly above the gains in productivity. The rise in unit labor costs should therefore stay elevated, as should underlying inflationary pressures. SEI believes this will continue to present a major challenge for monetary policy makers.

At the start of 2024, hopes were high that global central banks would begin to cut policy rates in order to support their economies. Market expectations indicated that the US Federal Reserve would engineer six to seven cuts to the federal funds rate. SEI made the argument that central banks would be reluctant to cut policy rates if inflation stayed above target. Has your view changed?

No, it has not. We saw no reason for such optimism, and we stuck to our review that the Fed would make only three 25-basis point reductions totaling three quarters of a percentage point. In our review, any surprises from the Fed would more likely come in the form of fewer, not more policy rate cuts this year. In March, the Fed updated its economic projections, though the median forecast for the federal funds rate did not change. By the end of this year, the median forecast remains at 4.6%. The median estimates for year end 2025, 3.9%, and 2026, 3.1%, also have ticked up slightly.

How would you interpret these changes?

The decision makers at the Fed still seem to be betting that they can safely lower rates three times this year and still see lower inflation against the backdrop of a resilient economy marked by a structurally lower unemployment rate.

What is your view on what moves global central banks will make?

Monetary policy moves by the major central banks have been fairly uniform since the global financial crisis. It probably will stay this way given the similar challenges these countries are currently facing. The European Central Bank might be the first central bank to cut its policy rate, given its squeaker economic outlook relative to the US and appreciably lower inflation rate than the United Kingdom. The risk to growth still appear to be to the downside. Global central banks are walking a tightrope with respect to balancing inflation and economic growth.

Thanks, Jim. We always appreciate your insights. SEI is focused on the major issues that are of interest to our clients. We incorporate these discussions into our advisory process as the impact varies based on each client's goals. For more of SEI's insights, read our latest economic outlook available on our website.