Proceed with Caution: Geopolitical Tension, Employment Remain Threats to Inflation

At first glance, a minimal decrease in inflation is justified for 2024.

In the U.S., the inflation rate dropped to 3.4% in 2023, down from 6.5% the previous year. The good news is that the easing of monetary policy is still a question of ‘when’ rather than ‘if’ in 2024. Several factors will challenge the task of lowering global inflation to 2% and despite the optimism, it’s particularly important to keep an eye on developments across the globe.

Historical Perspective

But before we look ahead, we take a step back to a similar economic period about 45 years earlier. In the late 70s and early 80s, the U.S. was plagued by high inflation, partly due to spiking oil prices, just as we have seen today. To combat rising costs, Paul Volcker, Chair of the Federal Reserve, raised interest rates to 21.5% in 1979. The outcome was costly – quite literally. Inflation decreased substantially, but at the cost of a widespread recession, with an unemployment rate of 11%.

The good news is that this is not in the cards but is a cautionary tale of why we should stay vigilant for global changes. While unlikely, if there was an escalation of conflicts like those in Ukraine and the Middle East that spikes energy prices, high interest rates could persist longer than previously predicted. Another “worst case scenario” is that inflation will prove more persistent depending on consumer spending and investments. But for now, we’re on track for a soft landing.

Regional Impacts

Regional differences exist in terms of the magnitude and impact of inflation this year. What we do anticipate is just the slightest relaxation of monetary policies, including in the US, , but we don’t expect it to be as low as those we saw before the pandemic.

Unfortunately, sectors that remain the most inflated are services and energy – and this is especially true in the EU. The services sector saw major impacts from inflation, and it’s also the sector that has increased in demand post-pandemic. This sector touches everything from retail, hospitality, banking, and education to healthcare services, which is why it’s important that the labor market should be closely monitored. Additionally, in the energy sector, prices are still higher than they were before the impacts of the pandemic. For materials such as steel, cement and chemicals, steep costs remain stubbornly high, and substantial or immediate relief is not on the horizon.

Regardless of the industry and its sectors, all eyes are on the Federal Reserve and the European Central Bank (ECB). Both take a cautionary approach as they try to balance lowering inflation and steering away from a recession. While the Federal Reserve and the ECB differ in location, mandates, policies, and legal frameworks, they do have this in common – combating inflation.

Central banks and policymakers are tasked with addressing inflationary pressures while ensuring sustainable economic growth. Both the Fed and the ECB are committed to targeting 2% inflation and will go a long way to achieve this goal.

In the U.S., the Fed is closely monitoring any labor market developments as it walks the line of its dual mandate which includes maximizing employment. While the central bank wants to stimulate economic growth and employment, maintaining price stability is crucial to keep inflation at bay.

Conversely, the ECB is more focused on ways to primarily tackle inflation. You will not hear a lot of talk from the ECB about avoiding a recession by using monetary policy.

Cautious Approach

Are central banks on the brink of beating the rising inflation that has undermined economies since the end of the pandemic and lowering interest rates? The message from many economists is “not so fast.” Nobody is declaring victory just yet.

Both central banks see contrasting forces. The declining cost of energy and industrial goods continues to drive significant falls in inflation, but pitted against this decrease are rising wages and geopolitical tensions.

With 2024 being a big election year for not only the U.S. but for Mexico, India, Russia, the EU and others, risk managers should be aware of and continue to monitor geopolitical trends. The impact of the election results as such does not drive global economic development. Policies do, and particularly those –reflecting a more a more isolationist approach to foreign policy that affect trade.

Businesses should continue to bank on the baseline scenario of mild relaxation of monetary policies unless the business is sensitive to a significant increase in interest rates. If so, then financial tools can provide an additional layer of protection.