There is no guarantee of an ‘immaculate disinflation’ in the US.

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We’ll keep you updated on the US Federal Reserve’s interest rate setting committee meetings. In June, annual inflation in the US dropped to just 3%, the lowest it has been since March 2021. Surprisingly, it even fell below the traditionally inflation-challenged Japan, where price growth reached 3.3%. What’s more impressive is that despite the Fed’s aggressive 500 basis point rate rises over the past 18 months, joblessness has hardly increased, and the chances of a recession are decreasing.

The upcoming meeting of the US Federal Reserve’s interest rate setting committee may give them a sense of satisfaction. With annual inflation in America dropping to a low of 3% in June, the lowest in several months, the Fed’s efforts to control inflation seem to be paying off. In fact, inflation in Japan, which has historically struggled with inflation, is higher at 3.3%. Remarkably, despite the Fed’s significant rate hikes over the past year and a half, joblessness remains low and the odds of a recession are decreasing.

Chair Jay Powell’s skill in achieving this “immaculate disinflation” of the US economy will be put to the test. If he succeeds, he will go down as one of the most successful Fed chiefs in history. Even the renowned Paul Volcker, who famously raised interest rates to 19% in the 1980s, ended up causing high unemployment rates. However, a smooth transition to lower inflation without a significant downturn is far from guaranteed.

There is still a possibility that interest rates will need to be raised further. Investors are anticipating a 25 basis point rise this week. The Fed’s rate projections also suggest another increase later this year. The recent drop in inflation was largely due to falling energy prices, and core inflation remains at double the Fed’s target of 2%.

However, to further decrease pricing pressures, demand may need to be curbed, leading to more job losses. While vacancies have decreased, the labor market is still strong, with wages showing solid growth. The Fed may face a challenging trade-off between its goals of maximum employment and price stability as it nears its target. The Bank for International Settlements warns that the final phase of disinflation could be the most difficult.

Moreover, it is uncertain how quickly the Fed’s previous rate hikes have affected the real economy and how much more impact they will have. A recent paper from the Kansas City Fed suggests that the peak deceleration in inflation could occur a year after tightening, but there is high uncertainty surrounding this estimate. Regardless, economists agree that a significant portion of the rate rises still need to be felt, which could further drag down growth.

The peculiar combination of high rates, decreasing inflation, and limited unemployment can partly be explained by post-pandemic idiosyncrasies. The depletion of savings and fiscal support has boosted demand, while a shift from durable goods to services has relieved some price pressures. Achieving an immaculate disinflation scenario will depend on how these factors continue to evolve.

The optimism for a soft landing is not exclusive to the US. Some emerging markets that raised interest rates before advanced economies have successfully reduced inflation without significant damage to output. European markets are also becoming more hopeful, with inflation in the eurozone and the UK declining last month, and their economies showing resilience. However, in this uncertain climate, the pendulum between soft and hard landing scenarios can swing frequently.

While it is certainly positive that inflation is falling in the US and globally, the unusual nature of this post-pandemic interest rate cycle should give investors hoping for a soft landing some pause for thought.