Weekly Update - A long last mile

January's figures for US inflation, including a bump in the services ex-rents component, suggest price pressures are still too hot for comfort for the Federal Reserve (Fed). What is more, January's activity and jobs figures show the economy is still in good shape. All of which confirms our scenario of a soft landing for both the economy and inflation and a gradual rate cuts cycle.

Services buck the trend on inflation. January’s inflation figures broke with the recent string of positive surprises, up by 0.3% on the month (rather than the 0.2% consensus estimate), which put year-over-year inflation at 3.1%. The main culprit was core inflation, up 0.4% on the month compared to 0.3% expected, leaving its year-over-year rate stable at 3.9% (chart 1). And the main driver of this was services inflation, which continues to bowl along a pace incompatible with the Fed’s 2% target. In part, this was due to housing costs (33% of the CPI) which are still rising faster than their pre-Covid average and will take a while to get back to normal given the way the index is designed. But the sting in the tail was non-rent services inflation, which had been heading toward normal but jumped back to its 2022 average month-on-month pace in January. It is one of the components most closely watched by the Fed, given its rigidity and sensitivity to monetary policy. These US figures do not alter our scenario for inflation, which we still think will continue to ease in 2024 but do confirm this will be a lengthy process.

Economic activity remains resilient. While the pace of disinflation has slowed, the pace of economic activity remains resilient. After ending the year with strong growth (4% in volume), retail sales fell by 0.8% over the month. However, this decline mainly reflects the vagaries of the weather in January. January's various survey and employment data still suggest that economic activity will remain buoyant in the first quarter of 2024. For the year, the US economy should post resilient growth, still underpinned by real growth in household incomes and firm investment growth, given the easing of financial conditions and a still expansionary fiscal policy in 2024.

Rates to fall gradually from late spring. Buoyant activity and January's negative surprise on inflation led markets to reassess their expectations for the Fed’s rate cuts (chart 2). A March cut was broadly ruled out following the Fed January meeting and the chance of a rate cut at the May meeting was since significantly scaled back. Similarly, money markets had been expecting 6 cuts in 2024 but following January's data trimmed this back to 4, closer to our scenario of rate cuts starting in late Q2. In a scenario of persistently strong growth, with gradual disinflation of service prices and after two years of inflation above its 2% target, we think the Fed will keep its policy rate at 5.5% for the next few months and tread cautiously when it comes to starting its rate-cutting cycle.
 
In the highlights of the week, we chose to talk about British growth and inflation figures as well as the Swiss inflation figures: 
 

• Activity and inflation data show a UK economy close to stagflation. On the one hand, Q4-23 GDP contracted by 0.3% quarter-on-quarter (versus -0.1% expected by consensus), essentially reflecting weak household consumption. With GDP having contracted in Q3-23, the British economy is now in technical recession. On the other hand, inflation continues to only slow gradually, with headline and core inflation stable at 4% and 5.1% on a year-over-year basis in January. All in all, while these figures complicate the Bank of England's task, it is likely to maintain its key rate at 5.25% over the next few meetings, with the emphasis on keeping inflation under control. We expect the Bank of England's rate-cutting cycle to come into the second half of the year.

• Unlike in the major developed economies, inflation in Switzerland is already below the Swiss National Bank's target. Indeed, disinflation has continued more rapidly than consensus expected, with total and core inflation for January coming in at 1.3% year-on-year. With this pleasant surprise, the Swiss Central Bank may be in a position to be amongst the first of the developed economies’ central banks to cut rates this year.

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