Inflation leading indicators still softening

It might be expected that G7 central bankers, in attempting to judge inflation prospects and the appropriate policy stance, would be paying close attention to indicators that signalled the recent inflationary upsurge.

Such indicators include:

• Broad money growth, which led the inflation increase by about two years.
• The global manufacturing PMI delivery speed index, a gauge of excess supply / demand in goods markets, which led by about a year.
• Broad commodity price indices, such as the S&P GSCI, which displayed a sharp pick-up in momentum six to 12 months before the inflation upsurge.

Indicators that provided little or no warning of inflationary danger include measures of core price momentum, wage growth, labour market tightness and inflation expectations, i.e. indicators previously cited to argue that an inflation rise would be “transitory” and now being used to justify continued policy tightening.

Chart 1 shows G7 CPI inflation together with the three informative indicators listed above, with appropriate lags applied.

Chart 1

The three indicators have fallen far below pre-pandemic levels, suggesting that CPI inflation rates will return to targets – or undershoot them – in 2024.

Core inflation and wage growth moved up more or less in tandem with headline inflation during the upswing. Hawkish central bankers need to explain why they expect an asymmetry on the way down.

A possible “monetarist” argument for inflation proving sticky is that the stock of money remains excessive relative to the price level. The judgement here is that any overhang is small and – with monetary aggregates stagnant / contracting – will soon be eliminated.

The G7 real broad money stock is 3% above its 2010-19 trend, down from a peak 16% deviation in May 2021 – chart 2.

Chart 2

While agreeing on the destination, the indicators are giving different messages about the speed of decline of inflation.

The PMI delivery speed indicator and commodity prices are more relevant for goods prices, with recent readings consistent with the expectation here of goods deflation later in 2023.

Broad money trends, by contrast, suggest a temporary slowdown in the rate of decline of CPI inflation during H2, reflecting a stabilisation of money growth during H2 2001. This resulted from a reacceleration of US broad money following disbursement of a third round of stimulus payments.

A possible reconciliation is that the bulk of a fall in services inflation will be delayed until 2024. Such a scenario would suggest a slower reversal of policy rates and an extension of real money weakness, with negative economic implications.