Inflation falls: how far will interest rates follow?

Markets were cheered by last week’s US inflation numbers, even though they showed a modest decline and were only marginally better than expected. This week we get the UK numbers, which should show a much bigger decline and the prospect of inflation being at, or around, the Bank of England’s 2% target for the next 12 months. At the end of this month, eurozone inflation should also improve.

All of which is very good news and should pave the way for interest rate cuts to start in June. How far they go depends, of course, on the data. In Europe and the UK the inflation outlook is set fair, and although both economies are improving, especially the UK, we expect the respective central banks to cut further than markets are currently pricing. That pricing sees cuts by year-end of 68bps in the eurozone and 56bps in the UK. We expect the out-turns to be nearer the 1% mark.

Matters are more murky in the US where inflation has been sticky of late. In particular, and as we have discussed many times in previous Weekly Perspectives, the bizarre treatment of rent in the US CPI could keep inflation higher for longer. The hope for rate cuts depends on the significant economic slowdown that we expect. In short, the US consumer has been spending ahead of their income and is due a retrenchment. Buoyant consumer confidence, which has powered the US consumer over the past year and more, has started to slide and we expect further softness in consumer spending. This won’t be anything spectacular, but it should take the edge off growth and generate renewed downward pressure on prices.

Meanwhile, the economies in Europe and the UK and growing more rapidly. As this is coming off a low base – mild recession, in fact – this should not be a barrier to rate cuts. Indeed the UK, which was one of the worst performers in terms of growth and inflation last year, should look much better on both counts. Data released last week showed firm growth, which was much stronger than expected, and we see further good news on this front.

Global recovery, falling inflation, lower interest rates … this all constitutes a favourable background for financial markets and we see further gains over the balance of the year. Until next week, goodbye from me.