Kerry Craig

Macroscope | As inflation eases, how will central banks respond on interest rates?

The many moving parts of the inflation outlook, including housing and wages, make it difficult to determine the exact path for policy interest rates

The easing of price rises in recent months reduces the risk central banks will overcommit to fighting inflation, but that is not the same as cutting rates

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A worker stocks eggs on a shelf at a grocery store in Detroit, Michigan, on January 18. While egg prices remain stubbornly high, other price rises are easing, a sign that inflation may have peaked. Photo: Bloomberg

Kerry Craig

Published: 10:00pm, 27 Jan 2023Updated: 11:25pm, 27 Jan 2023

Inflation has peaked. The slowing pace of price increases across the world has dispelled many of the fears about a return to 1970s-style stagflation and supported both equity and bond market rebounds this year.

Falling inflation is one thing, but a return to where central banks want it to be is another. This has changed the question for investors from, “how high will inflation go?” to, “how fast will it fall?”.

In economic terms, the world is now going through a period of disinflation. This means prices of many goods and service are still rising, just not as fast. This is a reversal of the narrative that dominated the economic experience of 2022. As such, it will have important implications for policymakers and investors alike.

Disinflation is being driven by powerful forces. Energy prices are well down from the peaks experienced last year. At the time of writing, the price of a barrel of Brent crude oil, the international benchmark, is 36 per cent lower than the peak in March 2022. The price of natural gas in Europe is down 82 per cent from its peak and at levels last seen in September 2001.

Beyond the dramatic fall in energy costs, the unwinding of supply chain disruptions and the weaker demand in global manufacturing has improved the global supply and demand imbalance. The New York Federal Reserve’s Global Supply Chain Pressures Index has fallen back to mid-2020 levels as freight costs fall and supplier delivery times improve.

Meanwhile, the weakness in global activity is reducing demand and the global manufacturing PMI shows business activity contracting sharply. The world is slowing and bringing inflation down with it.