JAN-DAAN VAN WYK: Inflation shows it still has legs as targets remain out of reach

Last week was eventful for inflation watchers. After a disappointing run of inflation figures in the first three months of the year, financial markets rallied on positive US consumer inflation data, only to be tempered by the Federal Reserve’s still hawkish message, delivered shortly thereafter.

The Fed’s caution — and decision to keep interest rates unchanged — followed the surprise decision by the European Central Bank (ECB) to reduce rates the previous week. It was a historic decision, the first time the ECB has moved before the Fed. It cut by 25 basis points, even though its forecast points to average annual headline inflation remaining above its 2% target until 2026. 

The ECB is not alone in facing the challenge of returning inflation to central bank targets. The Reserve Bank expects SA headline consumer inflation to return to the midpoint of its 3%-6% range only in the second quarter of 2025. In the US, the latest Reuters poll of 116 economists found that most expect inflation to reach 2% only in 2026. 

Inflation expectations in SA and the US also highlight that consumers are not convinced inflation will fall to central bank-targeted levels. In the US, the New York Fed survey of consumer expectations in May found respondents don’t believe inflation will come anywhere near 2% in the next five years. Instead, they expect inflation to be 3.2% a year out, 2.8% three years out and 3% five years out.

In SA, the Bank’s monetary policy committee (MPC) noted that consumers, businesses and trade unions believe inflation will not reach 4.5% in two years. According to the Bureau for Economic Research inflation expectations survey, respondents project a decline to 5.3% in 2025 and 5.2% in 2026. The MPC thus said the Bank needed to deliver on the target sooner rather than later to re-anchor expectations.

This is against the seemingly positive backdrop of US headline consumer inflation falling to 3.3% in May and personal consumption expenditure (PCE) inflation, the Fed’s preferred measure, declining to below the psychologically significant 3% level, at 2.7% in April.

Biggest risks

The consistent upticks in inflation in the first quarter of the year highlight the risk of getting too excited about one month’s data. Thus, many economists prefer to look to rolling periods of inflation to get a sense of underlying inflation movements. These are not as favourable in the US as the headline inflation figures suggest. The median of six rolling inflation measures is still above 3% over one-, three- and six-month periods. These measures include headline, core, market-based core, core services ex-housing, median PCE and trimmed mean PCE.

SA’s 5.2% inflation rate in April falls within the central bank’s target range but is still well above the 4.5% the Bank is committed to achieving before loosening monetary policy.

The biggest risks to central banks’ success in fighting inflation remain geopolitical risks due to the wars in Ukraine and the Gaza Strip. ECB president Christine Lagarde also cited extreme weather events and the climate change crisis as potentially driving up food prices. 

In the short term, inflation headwinds include strong consumer spending, sticky services inflation, high shelter inflation, a likely hangover from the low interest rate environment and a labour market that is giving mixed signals now but remains tight. Services inflation has been significantly higher than goods inflation and tough to bring down. It signals demand is still high in the economy.   

In the medium to long term, inflation could also experience upward pressure from the deglobalisation that is under way and fiscal outcomes after the US elections. The US, in particular, will no longer benefit from China’s exported deflation because of the tariffs it continues to impose on Chinese goods. The world’s largest economy is also likely to contribute to inflation if it produces everything at home.

On the political front, if Donald Trump becomes the next president his proposed tax cuts would be inflationary, as would the large government spending programmes that are likely to be implemented by a Democratic government.

The plethora of inflationary headwinds and possible geopolitical and climate disruptions mean inflation will most likely be more volatile and harder to predict in the years ahead. Thus, investors are well advised not to base their decisions on falling and lower inflation rates and to ensure their investment strategies give them exposure to a diversified mix of asset classes.

Each of these asset classes should be actively managed by investment experts who can proactively respond to any geopolitical surprises or changes in the macroeconomy, especially the inflation and interest rate outlook.

• Van Wyk is senior analyst (investment management) at Stonehage Fleming.