Analysts say investors’ expectations that rates are near their peak are likely to prove too optimistic

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Economists are at odds with markets on investors’ bullish bets global economy is set for a soft landing and interest rates they are near their peak.

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Markets on both sides of the Atlantic rose in recent weeks as the UK followed the US and the eurozone in the headlines inflation is declining faster than expected.

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“In all the major regions we have this sense of light at the end of the tunnel,” said Claus Vistesen, chief eurozone economist at consultancy Pantheon Macroeconomics Ltd.

The improvement in the UK, where the fall to 7.9 percent from 8.7 percent was the biggest monthly decline on record, was “the last shoe to drop,” he added.

We have this feeling of light at the end of the tunnel in all the major regions

Claus Vistesen

Few economists now expect depth recession many predict last year, but many warn that central banks will struggle in the “last mile” of their journey to sustainably return inflation back to their 2 percent targets without raising rates so much that job losses mount.

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With U.S. and euro zone central bankers meeting this week and their U.K. counterparts convening on Aug. 3, investors are hoping the latest good news on inflation will mean ratemakers will ease their plans to raise borrowing costs further.

Markets priced in the near-certainty of another quarter-point rate hike US central bank on July 26, but investors are betting that it will turn out to be a peak for US rates and that the Fed could begin easing policy in early 2024.

The European Central Bank is expected to swing for a similar hike at similar meetings next week, and the Bank of England is predicting an increase of at least that size next month.

Investors no longer expect UK rates to rise as high as the 6.5 percent they bet on a few weeks ago. Some think the ECB may also be close to a break after Klaas Knot, usually one of the most hawkish members of the ECB’s Governing Council, said on July 25 that a rate hike after the July meeting was “by no means certain”.

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But economists are not convinced that better data means growth in the coming quarters.

Some argue that the lagged effect of higher interest rates has yet to kick in and that economies are set to slow sharply.

Others say that if economies do indeed prove resilient and labor markets remain strong, central banks will eventually have to take a tighter monetary stance than markets are pricing in.

Unemployment remains near historic lows on both sides of the Atlantic, and official figures show wages are rising faster than central banks think is compatible with 2 percent inflation.

Robert Sockin, global economist at Citigroup Inc., said it would be “historically unusual” for central banks to get inflation back to target without “meaningful easing” of labor market conditions.

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“We need unemployment to rise (before central banks stop raising rates),” said Luigi Speranza, chief economist at BNP Paribas SA.

He still believes the lagged effects of higher interest rates will cause a recession in the US and a long period of slow growth in the eurozone, where inflation is now 5.5 percent, down from 10.6 percent last October.

Disinflation is back

Michael Metcalfe

Some economists believe a soft landing could occur in the US, where inflation has fallen from double digits to just three percent. Goldman Sachs Group Inc. now predicts only a 20 percent chance that the U.S. economy will slip into recession in the next 12 months, citing “the easing of financial conditions, the recovery in the housing market and the continued boom in factory construction.”

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Adam Posen, president of the Peterson Institute for International Economics, said U.S. inflation could fall without a recession in an economy where labor has traditionally had less bargaining power.

However, it would be a “heroic assumption” to expect inflation to develop in a similar way in the Eurozone, where workers had stronger rights. Eurozone PMI data released on July 24 signaled that the region could be heading for another quarter of economic contraction.

In the UK, meanwhile, Posen said policymakers had lost credibility and were trying to cut public sector pay unsustainably.

Although the government has settled some pay disputes and kicked off teacher strikes with a new 6.5 percent pay offer, it has yet to resolve a damaging dispute with the main doctors’ union. A much bigger challenge would be to reverse a 15-year period of decline in the relative value of public sector pay that has led to worsening recruitment and retention problems.

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In the private sector, figures released this month by the online website Indeed show that growth in advertised wage rates has slowed sharply in the US, while stagnating in the eurozone and still accelerating in the UK.

On July 19, Dave Ramsden, the Bank of England’s deputy governor for markets, appeared to warn investors against over-interpreting the latest inflation press. Pricing pressures are still “too high,” he said, stressing that ratemakers are focusing on wage growth and services inflation.

For now, however, even some in the UK are focusing on the positives.

“Disinflation is back,” said Michael Metcalfe, head of global macro strategy at State Street Global Markets.

Paul Dales of the consultancy Capital Economics Ltd. he said that while he still expected UK output to fall, the gradual falls, which add up to around 0.5 per cent, would be “the mildest recession we’ve ever had”.

Given how gloomier the UK’s outlook looked at the start of the year, he said, “this would still be classed as a really good result – basically a soft landing”.

© 2023 The Financial Times Ltd.

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