Unfinished business: slow core inflation decline offers central banks little comfort

Inflation pressures remain significant and the progress has been too slow to give central banks comfort. We expect yields to remain high for longer, whilst the bar for rate hikes is much lower than for cuts. 

We see more country divergence in the near-term, but the end game remains a recessionary environment. Recent global growth momentum has shown strong divergence: US data has reflected surprising resilience, while momentum in the euro area and China is fading (see Figure 1). Leading indicators in manufacturing have shown broad-based pressures for a while, but services now also seem to be facing a turning point (see Figure 2). Due to the strong 1Q GDP data revisions and second-quarter resilience, we upgrade our US real GDP forecast for this year by 0.6 percentage points (ppt) to 1.5%. We expect Europe will underperform US in the near-term but the end game is similar: we continue to expect a recession in the US to start late this year or early 2024, with other countries also likely to face recessionary environments.

Figure 1: Economic surprise indices

Figure 2: US, euro area and China PMIs

Headline inflation numbers set to fall in the second half of 2023, but core pressures remain significant and persistent. We expect headline inflation in the US and euro area to decline significantly over the coming months on the back of strong base effects (see Figure 3). Core disinflation will also continue, although we do not see core inflation below 3% by the end of this year: It could potentially be significantly later. Very tight labour markets are holding back a swift and sustainable return towards a 2% inflation. Even though US job creation is still strong, some gradual market softening is visible in various indicators (see Figure 4). Ultimately, we believe labour markets need to soften more in order to get inflation firmly under control.

Figure 3: Swiss Re headline and core inflation forecasts

Figure 4: Measures of US job market tightness (normalized)

More central bank tightening to come. The recent string of relatively resilient economic and firm inflation data has lifted nominal and inflation-adjusted (real) yields across economies. The US real yield curve was at the peak of this cycle in early July (see Figure 5). Because inflation adjusted yields are the most fundamental cost of capital, a higher real yield curve meaningfully tightens financing conditions towards the real economy. Still, given the slow progress on inflation and growth, we have revised up our peak Federal Reserve policy rate by 25 basis points (bp) and lifted our US 10-year yield forecasts slightly. Similarly, we upgrade our Bank of England terminal rate by 25 bp to 5.5%, with upside risks for a still higher terminal rate. We have also raised our 10-year Gilt yield forecast slightly. While central banks have been hiking for a while already, we still believe the bar for further rate hikes is much lower than the bar for rate cuts on the back of continued inflation pressures. As such, we see the hawks as continuing to hold sway.

Figure 5: US inflation-adjusted (real) yield curve is currently at the peak of this cycle

Figure 6: Market expected peak policy rates