Past the peak

Weekly

Oil prices should increase until the end of 2023 in response to persistent demand and supply uncertainties. A resilient global economy is keeping oil demand strong and the prospect of a positive summer season in the West will also support demand for transportation fuels. While oil prices have declined since the start of the year, short bets are likely to unravel in the coming months as the supply outlook has been shifting, too:

Although all recent signals point toward higher oil prices, markets remain volatile. Geopolitical developments are adding a layer of complexity, with Russia holding the key to stabilize markets through compliance on its own production targets, and also paving the way to more Saudi exports towards Asia to ease some of the tension between OPEC+. Overall, we expect Brent prices to increase throughout the year and average USD82 for 2023 (Figure 1). Nevertheless, these rising prices are unlikely to fuel an inflation spiral as oil prices are likely to remain 20% below 2022 prices.

However, several FOMC participants poured cold water on the idea of hiking in June, opting for a ‘wait and see’ approach. Phillip Jefferson, who has been nominated to be the Fed's next Vice Chair, argued that "skipping a rate hike" would allow officials to "see more data before making decisions about the extent of additional policy firming". FOMC participants are very mindful that monetary policy operates with long and uncertain lags. They are probably worried that the cycle may turn down abruptly in upcoming months. For instance, renewed bouts of stress in the banking sector could trigger a credit crunch. Also, while hard data have come out strong, the latest business surveys point to rapidly cooling momentum, while the household employment survey reported a decline in jobs (in contrast to the payroll survey) in May and an uptick of the unemployment rate. However, we think that the reality of strong economic momentum will strike back at the FOMC in upcoming weeks. Business surveys have tended to send excessively downbeat messages over the past few months (negative sentiment and softer goods price probably bias the results).

Whether or not the Fed delivers another rate hike is a close call, but overall, we think that FOMC participants will hold off this time (Figure 3). However, we expect the Fed to resume hiking both in July and September by delivering two final 25bps rate increases as still elevated wage and price pressures force its hand. Weaker momentum should materialize in end 2023-early 2024. As a result, the Fed should reverse course in Q1 2024.

In the Eurozone, inflation keeps declining but still remains far too high (Figure 4). The drop in headline inflation to 6.1% y/y in May (down from 7.1% in April) was larger than expected due to deflationary energy prices (-1.7%) and declining food inflation (12.5%). More importantly, however, core inflation, the ECB's guidepost for calibrating its monetary stance, declined to 5.3% (down from 5.6%), which was below consensus expectations and marked a four-month low. Unlike in April, selling-price expectations now show less divergence between goods and services. While core goods inflation decreased further to 5.8%, suggesting that the easing in supply bottlenecks and falling energy prices are increasingly feeding through, services also surprised on the downside at 5.0% (after 5.2% in April) despite continued tightness in the labor market, with the unemployment rate edging down to a record low of 6.5% in April. Thus, we expect price pressures, especially for services, to remain strong and elevated during the remainder of the year. This is also when inflation uncertainty is the highest, with wages still accelerating and robust demand, for tourism notably (Figure 5). The base effects from the nine-euro-ticket for public transport in Germany last year will also push services inflation up in June. As a result, the core inflation rate will decline only slowly. As money supply keeps contracting, it is hard to see a relapse of inflation, even though some bumps along the way of normalizing prices cannot be ruled out (bar any financial sector accidents or potential crisis event) (Figure 6). Over the medium-term, inflation will remain above the ECB's 2% price-stability target, with headline inflation averaging almost 6% this year and about 3% next year.[1]

[1] Note that an unconditional comparison of current inflation dynamics to the last episode of high inflation during the 1970s suggests that it could take more than five years and a significant increase in unemployment to sustainably bring back inflation back to target.

Broad price pressures still create a challenging environment for monetary policy in the Eurozone. The conspicuous decline in inflation is unlikely to dissuade the ECB from further raising interest rates. Also the lack of spillover effects from US banking-sector stress means that financial stability concerns will be insufficient for the ECB to abandon its restrictive monetary stance. However, the disappointingly small rebound in German industrial production in April, deteriorating business confidence, and stagnant investment suggest that the ECB would need to decide on a policy rate path that does not excessively slow aggregate demand (considering that the impact from rapidly tightening financing conditions operates with considerable lag).

Since the normalization of inflation is more protracted than in the US, high core inflation will reinforce the ECB Governing Council's conviction that further rate increases are still needed (Figure 7). After the 25bps hike at the last meeting we forecast three more 25bps hikes in the next policy meetings in June, July and September for a terminal rate of 4.0%. This would mean the ECB maintains a restrictive stance in 2023 despite stagnating growth until Q1 2024.

Unlike most other central banks, the Bank of Japan (BoJ) stood firm on its ultra-loose monetary policy stance and resisted the multiple headwinds that led to a 26.5% JPY depreciation vs the USD[1] since the end of 2020 – FX intervention included (Figure 9) – and speculative attacks on the Yield Curve Control (YCC) policy. As inflation starts to recede (after peaking at 4.4% y/y), we think that the BoJ policymakers will refrain from making a sharp turn this year. Instead, we expect them to opt for a further relaxing of the YCC objective, proceeding with a small hike that ends the policy of negative interest rates (though real interest rates remain negative for now).

[1] Trough of 31% as of September 2022, only partially reverted after the FX intervention

The BoJ decisions will have implications for the rest of the world, given Japan's creditor status and its large holdings of foreign assets.[1] The increase in yields that would follow the exit (total or partial) from YCC would increase the investment appetite for Japanese bonds. The return to the market would be welcomed by both Japanese investors repatriating their money or overseas investors in search of attractive yields on a safe-haven asset. Furthermore, it would coincide in time with the gradual withdrawal from the market of other central banks in advanced economies. For instance, Japanese investors (both public and private sector) hold around 6% of French sovereign debt.

At the same time, the BoJ might rebalance asset purchases towards US Treasuries to contain a potential appreciation of the JPY (as they did in the early 2000s). It is rather in the event of continued inaction when Japanese intervention to avoid a further depreciation puts upwards pressure on US yields. After all, Japan is the second- largest holder of FX reserves and the main foreign holder of US debt (although very close to China, and with a share that has decreased over time (Figure 12)).

[1] In terms of net external assets, Japan remains the largest in the world ahead of Germany and China

In Germany, construction companies in particular have used the general upward trend in prices to significantly expand their profits. Besides the agricultural sector, construction has seen the largest increase in profit margins on average – also compared to other large European economies (Figures 15 and 16). While there was still a high order backlog in German construction – both in terms of volume and value – dating back to before the pandemic and the war in Ukraine, it was amplified by low capacities, increased building-material prices and delivery bottlenecks. The cost of material has dropped again after supply-chain disruptions were resolved, and persistently low salaries in combination with strong prices increases have led to increased margins in the sector, particularly in civil engineering.

Similarly, Italy's construction sector was able to increase prices given the pick-up in demand in the last couple of years. Indeed, the tax credit related to the "super bonus" measure implemented to improve the environmental efficiency of the housing stock pushed up demand but at the same time inflated construction-related prices. Even though we expect the housing-efficiency investment to continue, also supported by the NGEU resources, and so demand to remain buoyant, we expect a correction in the coming quarters, given also that the generous government support has been fine-tuned and re-targeted.

In contrast, corporate margins in services have been under heavy pressure. While energy and transportation services are oligopolistic sectors with strong market pricing power, the services sector, including hospitality, B2B services and ICT, has struggled, with margins sitting well below their pre-pandemic averages (Figure 17). In addition, these sectors have suffered from accelerating wage (amid a high share of minimum-wage earners[1]) and input costs (Figure 18), as well as stiff competition and negative productivity growth (since the pandemic). This has limited the extent to which they can increase their selling prices above input costs, despite resilient demand for services. Indeed, business surveys in Spain show that expectations of future prices are falling. With non-negligible wage increases expected in the four major Eurozone economies for at least the next two years[2] (Figure 19) to offset last year's real income losses caused by high inflation, pressure on margins will continue.

[1] In France the minimum wage (‘Smic’) is indexed to CPI inflation. Businesses with a large share of minimum-wage earners thus faced a large twin cost-push shock in 2022, from higher energy prices (though many contracts in the service sector are not directly indexed to wholesale electricity and gas prices) and a higher wage bill.

[2] See our report No quick wins : more jobs but little productivity in the Eurozone.

The margin catch-up in the services sector should keep services inflation sticky this year. The latest PMI surveys on prices suggest that margins started to recover in Q2 2023 in the services sector amid easing input costs (such as energy) and improved global supply conditions. According to the latest ESI surveys, corporates in the services sector plan to keep selling prices elevated in the months ahead (Figure 25), which should support margins. Accelerating wages should, however, put a lid on large margin expansion. Overall, we expect the partial catch-up of services margins to limit the decline in services price inflation this year.

However, in other sectors (food industry, manufacturing, energy and retail), we expect some margin squeeze by the autumn, which should contribute to push down headline inflation toward +4-4.5%, from +5.1% in May. Corporates in the retail and manufacturing sectors already expect to ease their selling prices in the months ahead (Figure 24). While for now cooler selling prices largely reflect sharply lower input prices and the ending of supply-chain disruptions, we expect margins to take a hit from the autumn. Demand for manufacturing goods has been declining since mid-2022 and we expect further falls in the months ahead as goods consumption is typically more sensitive to tighter financial conditions than services consumption. Retail manufacturers in particular will be forced to take a margin squeeze as high inventories need to be depleted. In the food industry and retail, we also expect some margin squeeze amid public and government outcry over elevated margins. This should contribute to the rapid deceleration in food inflation that we expect from end-2023. Lower food inflation will be the main pull-down factor to headline inflation by end-2023, dragging it down by around 1pp between May and Q4 2023.