Central banks in the G-7 economies are dealing with persistent inflation within a slowing global economy—also known as stagflation.
While central banks have adhered to a policy maintaining inflation at a 2% target, only Canada and France have kept inflation below 2% over the past 12 months, which is primarily a function of their soft economies.
The inflation rate in the euro area is 2.4%, while Japan and the U.K. have averaged greater than 3%.
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Varying responses to inflation
Despite sticky inflation, only the United States and Canada cut their policy rates in September in response to their slowing economies and labor market uncertainty.
The overnight index swap market is now anticipating that Fed will make another 50 basis points of reductions through the end of the year and that the Bank of Canada will make one more rate reduction.
Other G-7 central banks, however, have responded differently as they wait to see the full impact of U.S. tariffs.
In the U.K. and Japan, the OIS market sees little chance of additional rate cuts with inflation in both countries exceeding their 2% targets over the past 12 months,
This is at a time when unemployment in the U.K. increased to 4.7% in July from 3.6% in 2022, with real GDP growth of only 1.4%.
Japan’s economy has avoided a recession but remains sluggish. With a new prime minister, Sanae Takaichi, looking to put forward fiscal expansionary policies and advocating a more accommodative monetary policy, investors have scaled back expectations of a rate hike to a 27% probability, down from 60% last week.
Among the euro area economies, France’s latest inflation reading was 1.1% and Germany’s was 2.4%.
But even with France’s unemployment rate at 7.3% and Germany’s manufacturing sector reeling from China Shock 2.0, the OIS market anticipates the European Central Bank to pause its rate cuts.
In that case, the narrowing interest-rate differential would bolster the euro and have a moderating effect on Europe’s inflation.
With most of the G-7 deep into a post-pandemic interest rate regime change, conditions are coalescing for higher inflation across most of the advanced economies.
