multi-asset
How to foster disinflation without a recession
The US economy appears to be slowing amid several points of deteriorating data. What does easing growth signify and what could the Federal Reserve (Fed) be willing to tolerate in order to curtail inflation? This week’s edition of Simply put considers the interplay between growth and inflation and asks what it will take to tame inflation.
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The economic slowdown gathers
The US economic slowdown is upon us. The economic surprise indices leave little room for doubt: data produced by the US economy are worse than expected and have been since May. The markets responded rather violently to the July Nonfarm Payrolls jobs report, and it's important to understand that this reaction was part of a change in the current economic narrative.
One data point does not make a trend, but the sequence we are witnessing reflects an altered course in terms of growth, particularly for the US economy. While a slowdown clearly doesn't mean a recession, it is necessary for the Fed to stymie inflation durably.
However, the question for this week’s Simply put is: how much growth does the Fed need to bring inflation back below the 2.5% mark?
Yesterday's growth is tomorrow's inflation
A key point of modern monetary policy is: a softening of the underlying economy is the best weapon against inflation. When the economy slows down, demand generally weakens, which prevents companies from trying to raise prices. In the most extreme case, if demand is contracting, these same companies may even lower their prices temporarily in order to attract the (scarcer) consumer. If such price cuts are sufficiently widespread, the economy will enter a period of deflation.
This interplay between growth and inflation exists but it is not instantaneous. The work of Keynes in particular has made economists quick to understand that prices adjust more slowly than quantities of goods and services.
Figure 1 illustrates the interplay between growth and inflation. On the face of it, coincident1 growth and inflation are not particularly correlated with each other. With a one-year lag, however, this zero correlation becomes positive or more than 28% over the 1947-2024 period. Historically, 1% growth in excess of potential translates into 0.21% inflation in excess of structural growth, which in turn reflects various fundamentals, including demographics, productivity, the functioning of the job market and certain geopolitical factors. In other words, when the US economy ‘over expands’ by 1%, one year later US inflation exceeds its inflation trend by an average of 0.2%.
According to the IMF, potential growth in the US is around 2.5%, while structural inflation is not far off 2.2%. So, when the economy grows by 3.5% a year, it generates average inflation of 2.4% the following year. This rule of thumb may shed some light on our central question: how much must growth slow for the Fed to reach its 2% target?
FIG 1. Scatterplot comparing current US growth and inflation (in excess of their respective trends)
Source: Bloomberg, LOIM. As of 22 August 2024. For illustrative purposes only.
A moderate slowdown needed
The need for a moderate slowdown is highlighted in figure 2, which explores the relationship between growth and inflation and projects inflation trends up to 2027. The graph assumes a structural inflation transition from current trend inflation, estimated by a filter set at around 3%, to the International Monetary Fund (IMF) estimate of 2.15%. This is combined with the delayed impact of a growth scenario where growth oscillates between 0 and 3% – or from 2.5% below to 0.5% above the US economy’s potential.
Key observations from the illustration include:
- Over the past year, US real growth has been 0.5% above potential, which aligns with the inflation projection for 2024 at about 3.2%, compared to the consensus of 3% and the IMF’s 2.9%. This extra growth contributes to delaying an increase in inflation
- Depending on the cyclical growth scenarios, different trajectories emerge. If US growth continues at recent strong levels, disinflation to around 2.5% is only achievable by 2027. Conversely, a cyclical downturn to 0% growth could reduce inflation to 2% by 2026
- A more moderate slowdown, bringing US growth back to around 1.5%, would be sufficient to allow the Fed to meet its inflation target with lower costs
This last scenario of moderate slowdown, aiming for a growth rate around 1.5%, is currently anticipated by the markets for 2025, with growth expectations at 1.7% and predicted inflation at 2.3%, versus the 2.8% shown in the chart's projections. Figure 2 is based on the delayed effect of growth on inflation, which is just one aspect of the broader market projections.
The main takeaway is that achieving disinflation without recession appears attainable with a targeted growth rate of 1.5%.
FIG 2. Simulated evolution of US inflation as a function of growth scenarios
Source: Bloomberg, LOIM. Figure as at August 22, 2024. Based on IMF growth and potential inflation data, and Hodrick and Prescott filters. For illustrative purposes only.
What this means for All Roads
Our portfolio allocations have recently become more cautious, favouring hedging assets at the expense of cyclical ones such as equities, credit, and commodities2. Consequently, we have increased our exposure to the duration risk premium, aligning our portfolio with a cautious yet not defensive stance.
While the path to achieving disinflation without triggering a recession seems to be on track, it is not devoid of risks. Currently, the array of indicators that inform our management process do not support adding more risk, aside from a renewed focus on duration, which represents the least uncertain element in the current disinflation scenario.
Simply put, a US growth rate that is 1% below potential would likely be sufficient for the Fed to achieve its disinflation targets.
[1] A coincident indicator is an economic statistical indicator that changes (more or less) simultaneously with general economic conditions and therefore reflects the current status of the economy.
[2] Holdings and/or allocations are subject to change.
Macro/nowcasting corner
The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises is designed to track the recent progression of macroeconomic factors driving the markets.
Our nowcasting indicators currently show:
- Growth data are still pointing to a subdued growth period, but the newsflow incorporated in our indicators did not deteriorate more
- Our inflation signal remains above 50%, reflecting months of mounting inflation pressures
- Data linked to monetary policy continues to indicate dovishness at the moment
World growth nowcaster: long-term (left) and recent evolution (right)
World inflation nowcaster: long-term (left) and recent evolution (right)
World monetary policy nowcaster: long-term (left) and recent evolution (right)
Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).
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