Charts of the Week: Inflated expectations

Stock markets and economic data In recent weeks, financial markets have been glued to political developments, with a particular focus on the policy implications of a new US administration. This political backdrop has buoyed US equity markets, which have responded positively to expectations of pro-growth policy shifts. However, beneath the surface, the economic data have told a more nuanced story. While inflation readings have consistently surprised to the upside, incoming growth data have fallen short of expectations (chart 1). Against this backdrop, the recent souring of sentiment in the US equity market seems less surprising, as investors reassess the balance between political optimism and the underlying economic reality.

Services inflation and monetary policy An additional reason, however, for that souring of sentiment concerns monetary policy. Although the US Fed cut interest rates by 25 bps this week, the commentary and forecasts left investors much more concerned about the scope for looser policy in 2025. These concerns have been amplified as well by incoming inflation data suggesting that service sector inflation has remained elevated (chart 2).

Broad money growth versus house price inflation There are, in addition, some forward-looking indicators that suggest inflation could pick up in the coming months. The recent lowering of policy rates across most major economies has been mirrored by an uptick in growth of broader measures of the money supply. As shown in chart 3, M2 growth in several major economies has gained momentum. This, in turn, has begun to translate—albeit with a lag—into stronger house price inflation. Against a backdrop where consumer price inflation has been above target and sticky this will potentially concern many policymakers.

Supply chain pressures and inflation surprises These inflation concerns could be further amplified in the coming months by a potential shift in US policy toward greater trade protectionism. As chart 4 illustrates, global supply chain pressures have played a pivotal role in shaping inflation dynamics—first by driving inflation higher during the pandemic and the war in Ukraine, and more recently by easing inflation as those pressures subsided. However, a resurgence of supply-side disruptions driven by renewed protectionist measures could trigger another inflationary spike. Such a scenario would likely force central banks to maintain a more restrictive monetary stance for longer, delaying anticipated interest rate cuts and adding to the challenges facing the global economy.

The Bank of Japan Standing in contrast to these broad global concerns was the Bank of Japan’s decision this week to signal patience regarding further interest rate hikes. Policymakers specifically opted to keep the policy rate unchanged. This decision appears justified, as inflation in Japan is currently holding just above the 2% target, with no significant upward pressure on prices to warrant additional tightening. Moreover, Japan's economic growth remains relatively weak, although nominal wage growth continues to be positive. Looking ahead, market-based inflation expectations have steadily risen in recent years, specifically with the 5-year breakeven inflation rate recently surpassing the 2% threshold (see chart below). If these expectations materialize, a more stable inflationary environment could provide the BoJ with a stronger case for further increases in its policy interest rate next year.

China Turning to the situation in China, the week’s economic data releases were underwhelming, as the economy’s regular monthly data failed to meet expectations. This is reflected in the Citigroup Economic Surprise Index, which reversed from a period of positive surprises and took a downturn. Specifically, retail sales growth slowed to 3% y/y in November, down from the 4.8% seen in October. Furthermore, China’s property sector remained in a dire state, with existing house prices falling by an additional 8.4% y/y (chart 6). These disappointing figures have reinforced expectations of further monetary easing by Chinese authorities and continued weakness in demand-driven consumer inflation. Additionally, producer prices have continued to decline, partly driven by excess capacity issues. This outlook has also solidified expectations of a prolonged period of low interest rates in China, contributing to a rally in the country’s bond markets and pushing yields to record lows.