Stephen Miller
RBNZ raises the policy rate for the fourth time this cycle by 50 bps to 1.50 per cent. Bank of Canada also hikes 50 bps
Proving itself one again as among the more aggressive of developed country central banks in meeting the current inflation challenge, the Reserve Bank of New Zealand (RBNZ) has “brought forward” monetary tightening, adding that the Monetary Policy Committee “remained comfortable with the outlook for the Official Cash Rate (OCR) as outlined in their February Monetary Policy Statement.”
However, the Committee “agreed that moving the OCR to a more neutral stance sooner will reduce the risks of rising inflation expectations” and further that a “larger move now also provides more policy flexibility ahead in light of the highly uncertain global economic environment.”
In its February Monetary Policy Statement, the RBNZ released projections showing the cash rate rising to 2.5 per cent over the subsequent 12 months and peaking at about 3.25 per cent at the end of 2023. It stated then that policy makers considered whether to lift the OCR by 50 bps, describing the decision to opt for 25 bps as “finely balanced” and further stated that the committee is “willing to move the OCR in larger increments if required over coming quarters.” In this meeting the Committee clearly decided to follow through on that scenario.
Bank of Canada also hikes 50 bps to 1 per cent
In a widely anticipated move, the Bank of Canada (BoC) announced a 50 bps increase in its policy rate to 1.00 per cent. Further, the BoC indicated a disposition to further raise the policy rate throughout 2022 with Governor Tiff Macklem saying he expects rates will return to what they consider the “neutral range” of 2 per cent and 3 per cent, with policy makers prepared to move “forcefully” if needed. The BoC also said it will stop purchasing government bonds later this month to start shrinking its balance sheet.
In a similar vein to the RBNZ, the move comes as the BoC ramps up its forecasts of inflation which is now seen averaging near 6 per cent in the first half of 2022.
The policy actions mark an acceleration of what’s expected to be an aggressive monetary tightening campaign, a tacit recognition from the central bank that it needs to quickly exit from ultra-loose policy before inflation becomes entrenched.
Any portents for the RBA? May RBA meeting must be considered “live”!
There are potential portents for the Reserve Bank of Australia (RBA) given some convergence of approach (albeit somewhat incomplete) since the February RBNZ meeting and March BoC meeting.
The RBNZ and BoC have been at the forefront of the retreat from the historically high levels of monetary accommodation applied by central banks in the wake of pandemic. The RBA has been among the most determinedly laggard. To some extent this is understandable: New Zealand had an earlier and more visible problem with inflation (currently a headline rate of 5.9 per cent in NZ and 5.7 per cent in Canada versus 3.5 per cent in Australia) and has what looks to be a tighter labour market (an unemployment rate of 3.2 per cent in NZ versus 4.2 per cent in Australia – Canada is higher at 5.3 per cent but is fresh off a couple of strong employment reports).
However, there is an emerging expectation that the RBA faces a confronting inflation challenge with the release on 27 April of the March quarter Consumer Price Index (CPI) inflation numbers.
NAB economists forecast a core (trimmed mean) inflation at a whopping 1.2 per cent for the quarter and 3.4 per cent over the year. If realised, the six-month annualised rate of core inflation would be 4.4 per cent. Bear in mind, this is even before the full extent of the price pressures unleashed by the Russia / Ukraine conflict have been reflected.
An outcome close to the NAB prediction would blow the RBA’s February Quarterly Statement on Monetary Policy (SoMP) forecasts out of the water. Abstracting from any fuel excise cut, these numbers suggests that by mid-year core inflation will be well out of the 2-3 per cent band at closer to 4.0 per cent on an annual basis.
The above scenario unambiguously intensifies the risks of waiting too long; being too “patient”.
Most of the economic commentariat have pencilled in June as the most likely point for a policy rate lift-off giving the RBA Board the benefit of viewing the March quarter Wage Price Index released on 18th May. However, there is evidence of rapid acceleration in wages already.
According to the latest NAB business survey, labour costs increased 2.7 per cent on a quarterly basis in March, which was well above the previous 2 per cent record reached more than 15 years before.
The RBA looks to be keenly aware of this. This accounts for the appearance of optionality in RBA Governor Philip Lowe’s April Statement and the retirement of “patience”. And the RBA May meeting must be considered “live”.
UK inflation releases surprise…again! More policy rate hikes coming despite BoE Monetary Policy Committee resistance
Meanwhile, March UK CPI increased by greater than expected. Headline inflation rose by 7.0 per cent over the year (Bloomberg consensus was 6.7 per cent), while core rose 5.7 per cent (Bloomberg consensus was 5.4 per cent).
In its communication since its March 17, the Bank of England (BoE) had revealed a disposition to temper market expectations of policy rate increases in 2022. There had been suggestions that BoE Governor Andrew Bailey was somewhat anxious that markets were pricing the policy rate reaching 2 per cent by year-end.
These latest numbers almost ensure a further rate rise when the Bank of England meet on 5 May and further suggest that a policy rate of 2 per cent by year end will be difficult to avoid.
Coming Up: ECB, Australian labour force (employment / unemployment)
This week’s meeting of the European Central Bank (ECB) Governing Council is likely to reaffirm the hawkish tilt maintained at its 10 March meeting. There had been an expectation at that meeting that the Russia / Ukraine conflict might forestall such a tilt.
However, with the ECB’s mission framed around an assertion that “price stability is the best contribution that monetary policy can make to economic growth,” and with inflation surprising on the upside since that last meeting, it seems that the hawkish tilt will persist.
In that vein, the ECB is likely to foreshadow the cessation of its quantitative easing (QE) program. At the March meeting, the ECB foreshadowed purchases of EUR40 billion in April, EUR30 billion in May and EUR20 in June and suggested that any subsequent asset purchases in the second half of 2022 would be data dependent and reflect its evolving assessment of the outlook. The inflation surge probably means that this meeting will (at least implicitly) indicate that the June purchases will be the last.
What will be of more interest will be any indication of the ECB’s thinking regarding movements in the policy rate. Markets are currently pricing circa 75 bps of tightening in the second half of the year. As with most developed country central banks, European interest rate futures seem to be ahead of what has been communicated by the central bank.
This will mean an intense focus on any of the President of the ECB, Christine Lagarde’s, comments that might indicate an advancement of ECB thinking closer to the path currently reflected in markets.
Like the Fed, the ECB finds itself in the realm of already having made a policy mistake, displaying a complacency regarding the magnitude, persistence and momentum in inflation through 2021.
Having let inflationary expectations escape the realm of being within their ability to comfortably manage, the ECB arguably needs to reaffirm with some vigour its inflation fighting credentials. A failure from President Lagarde to indicate such a stance might simply reinforce EUR weakness and compound the potential problems with destabilising inflation.
Australian March labour force (employment / unemployment)
The Australian March labour force data to be released today are likely reflect an ongoing tightening in labour market conditions. Consensus expectations are for an increase in employment of circa 40k and a further one tenth decline in the unemployment rate to 3.9 per cent, an unemployment rate not seen since the early 1970s.
Such outcomes suggest labour markets are very tight. There is also an abundance of evidence of wage acceleration with the latest NAB business survey revealing that labour costs increased 2.7 per cent on a quarterly basis in March, which was well above the previous 2 per cent record reached more than 15 years before.
This acceleration will certainly show up in subsequent statistical releases of the Wage Price Index (WPI). An outcome for the March quarter CPI significantly above the RBA forecast may mean that the RBA increases the policy rate as soon as May rather than wait for June (June would allow the RBA Board to have the benefit of knowing the March quarter WPI statistics released on 18 May). As previously discussed, most of the economic commentariat have June as the most likely lift-off point.
While wages growth (as measured by the most recent WPI – that being for the December quarter!) is at 2.4 per cent on an annual basis, it is a way short of where the RBA might wish to see it.
The WPI measure arguably suffers from a methodological inertia that belies the true state of the labour market. For example, the December quarter private sector WPI that includes bonuses showed annual growth of 3 per cent – the highest rate of annual increase in eight years. Measures that include bonuses are likely to be more pro-cyclical and more indicative of inflation currents than measures that exclude them.
US March CPI: The bond vigilantes ride on?
The US March inflation report revealed inflation at its highest level in over 40 years.
However, there were some indications that this might be the peak.
Core inflation also increased by less than expected. The 3-month annualised rate fell from 6.8 per cent in February to 5.8 per cent in March.
Falling yields after recent sharp increases indicated that the US bond market was comforted by the more benign core numbers.
But does this mean the bond market inflation vigilantes have ridden off into the sunset?
Maybe not. For one thing, if the core number hadn’t shown signs of rolling over soon then the inflation challenge was even more dire than thought.
For another, bond yields are still very low compared with the pre-Great Financial Crisis (GFC) “normality”.
In the wake of the GFC and the pandemic, the average 10-year bond yield from the beginning of 2009 to the end of 2019 was around 2.5 per cent.
That is a little lower than currently, but the US is closer to full employment and the Federal Reserve (Fed) still looks some distance from containing an inflation rate that is at its highest in 40 years.
With the Fed set to reduce its balance sheet, the buyer of last resort is no longer there to support lower yields.
The “trailing” real bond yield remains close to mid-1970s levels
Finally, there is the current gap between bond yields and core inflation.
As at end-March, the gap between the US 10-year bond yield and annual core inflation and– the “trailing” real 10-year yield – was, at around -4.10 per cent, the fourth lowest monthly reading since at least the 1950s (February 2022 was the lowest).
The last occasion when real “trailing” yields were close to these levels was in early 1975. That was a time when inflation expectations were way below the subsequent levels of actual inflation.
Even allowing for the circa 40 bps back up in yields so far in April, the “trailing” real yield is at levels that were last seen in the mid-1970s.
To put that in some context, in the three years leading up to the onset of the pandemic real “trailing” yields averaged around 0.40 per cent.
There are a few ways that the current gap between core inflation and the US 10-year bond yield might close.
A benign view is that inflation is essentially transitory, if elevated for longer than originally thought. Partly reflecting much tighter monetary policy, core inflation will return to the mid to high 2’s within the next year or two.
Accordingly, 10-year bond yields settle in the around the high 2’s or low 3’s and the gap between nominal yields and the “trailing” real yield reverts to something close to the 2017-2019 average.
A less benign, and arguably more realistic scenario is that the inflation is more intractable. In 2021 a complacent Fed let inflationary expectations escape the realm of being within their ability to comfortably manage.
Inflation expectations have a habit of being self-fulfilling through their effect on wage and price setting behaviour.
Accordingly, even if inflation does recede from here, it might not do so as far, nor as fast, as the Fed and markets currently assume.
Inflation is “sticky” at around the low to mid 3’s. Such a scenario reflects a “1970s-lite” outcome. A return to the 2017-19 average “trailing” real yield implies a 10-year yield reaching the high 3’s in the next year or two.
What the forgoing suggests is that even under relatively benign assumptions bond yields may have further to go.
The March inflation report suggests inflation still has momentum
There are troubling indications that inflation may well exhibit such “stickiness”.
Sophisticated measures of ‘underlying’ inflation (such as the Cleveland Fed median and trimmed-mean measures) show accelerating inflation. Such 3-month annualised measures of the ‘inflation pulse’ are above 6.5 per cent (above 7 per cent in the case of the trimmed-mean measure).
The bond vigilantes may ride on for a while yet.
By Stephen Miller, Investment Strategist
