By: Phil Kernen
As globalization increased over the last decades, the correlation has grown between developed market economies. While trading connections expanded and more producers looked to the same source for goods, economic data and growth patterns aligned. It became less common for one economy to zig while others zagged. Financial data in one economy generally mirrored those of another while they grew more or less in tandem. All of which now highlights the growing divergence of one data series and what it may mean for our economy here in the U.S.
In May, the Bank of England raised the Bank Rate to 1%. It cited global inflationary pressures which intensified following Russia’s invasion of Ukraine, including further supply chain disruptions due to the invasion and COVID-19 lockdowns in China. Inflation in the U.K. was 9% in April. The Bank expects it to rise further over 2022 to just over 10%, generally due to increasing prices across the board, but with specific mention given to increasing energy prices. The Bank states that while domestic inflation has risen, global pressures drive inflation expectations higher.
Compare this to the European Central Bank (ECB) forecasting year-end inflation at 5.1%. Inflation in the ECB was 7.5% in April. The ECB’s inflation projections have proved unreliable over the past year, and policymakers questioned the accuracy of its models, which failed to predict the spike in prices even before Russia invaded Ukraine in February. The ECB even took the unusual step of publishing an explanation of their forecasting errors. Adding to the challenge is a weakening Euro. Last year one Euro equaled $1.22. Today it is closer to $1.05 and moving toward parity with the dollar and raising the cost of imports. Though it may adjust its models, forecasting inflation has become much more difficult with so many moving parts.
We have two economies that experienced massive stimulus from their central banks through interest rate decreases and massive bond-buying programs. They also face the same global supply chain problems and rising energy costs. Yet one thinks inflation is going down and the other expects double-digit inflation. They can’t both be right.
How the difference reconciles will reveal where price levels may go in the U.S. CPI inflation was 8.3% in April, and forecasts expect May inflation to be similarly high. Like the ECB, the Federal Reserve Summary of Economic Projections expects inflation to moderate significantly for 2022 at only 4.3%. Like the ECB, the Federal Reserve has shown a tendency to under forecast inflation over the last year. Unlike the ECB, the Federal Reserve hasn’t explained any forecast errors.
The Fed recently raised overnight rates to 0.75%, on the way to their theoretical natural interest rate that neither propels the economy nor holds it back, currently estimated at 2.5%. On top of our domestic supply-chain problems sourcing labor and materials, the U.S. economy is subject to similar supply chain disruptions as the U.K. and Europe due to Russia’s invasion and COVID-19 lockdowns in China. The only material difference is the strengthening U.S. dollar.
The upshot is that the Bank of England is more right than wrong and estimates from the ECB and Federal Reserve are too low.
Disclosure: https://mitchcap.com/disclosure/
