Fed, RBA and BoE face challenges

From

Stephen Miller

Summary

  • Powell comments reinforce Fed’s aggressive stance. Markets roiled. Volatility to continue
  • Wage Price Index Price Index eases pressure on the RBA. Focus switches to today’s April labour force data and March quarter national accounts
  • A difficult time for the Bank of England. Strong labour market data and strong inflation data. BoE appears to prevaricate on appropriate course.
  • Canada CPI surprises on the upside

Powell comments reinforce Fed’s aggressive stance; markets roiled; volatility to continue

Federal Reserve Chair Jerome Powell’s comments on Tuesday continue to roil markets. In some of his most hawkish remarks to date, Powell said Tuesday that the US central bank will raise interest rates until there is “clear and convincing” evidence that inflation is in retreat. Chicago Fed President Charles Evans followed up overnight saying  that he sees a half-point rate increase at next month’s meeting and “probably thereafter.”

As mentioned last week, the Fed is engaged in the most delicate of central bank high-wire acts: charting a path between getting inflation back toward target without tipping the economy into recession.

Of course, a fortuitous mix of productivity gains, unblocked supply chains, increasing labour force participation, financial market resilience and the deft execution of the high-wire act by the central bank could see the US economy navigate the challenge ahead.

Unfortunately, history is replete with failed central bank attempts at such a high-wire act, particularly when faced with high and persistent inflation. The problem is compounded when it starts from a long way back coming off a period of historically high levels of monetary stimulus, and where “aggressive” counts as getting the real policy rate back close to zero, historically a real policy rate at such a level represented a reasonably accommodative stance for policy.

The forgoing suggests that despite a more aggressive approach from the Fed, financial markets may well remain in a volatile phase as they take time to assess the success of the Fed in reining in inflation without risking a substantial economic dislocation. The assessments arising from the Ukraine conflict (which also looks to be with us for an extended period) together with the fallout from China’s COVID lockdown only add to the sources of volatility.

Wage Price Index eases pressure on the RBA; focus switches to today’s April labour force data and March quarter national accounts

Wage Price Index slower than expected.

The March quarter wage price index (WPI) came in a little less than expectations with the private sector WPI coming in at 0.7% for the quarter for an annual increase of 2.4%.

Taken at face value, such an outcome should ease some of the pressure on the Reserve Bank of Australia (RBA). Having said that the numbers are not enough to forestall a further increase in the policy rate when the RBA meets on 7 June but for the moment should give markets some pause in any consideration of a ‘supersized’ increase of 40 or 50 bps. It may also suggest that the futures market’s expectation of a policy rate close to 2.70% by year-end indicates a more aggressive RBA than one indicated by either the data or the RBA’s own communication.

Some wage pressure evident

However, there are nevertheless other indications that wage growth is accelerating. According to the WPI release average wage increases are running at their highest levels in 9 years, albeit reflecting, according to the ABS a small proportion of in-demand market sensitive jobs recording large increases. The apparent relative modest overall increases evident in yesterday’s release are also at variance with industry surveys with the most recent March quarter NAB business survey showing labour costs increased 2.7%, which was well above the previous 2% record reached more than 15 years before. Certainly yesterday’s numbers will heighten the focus on the average earnings figures derived from the March quarter national accounts released on 1 June. Average compensation per employee has been growing at an annual rate close to 7% in the second half of 2021 (off a very low base). Any continuation of growth at that level is likely to mean less emphasis on the WPI figure alone.

Today’s labour force data also important

The Australian April 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 30k and a further one tenth decline in the unemployment rate to 3.9%, an unemployment rate not seen since the early 1970s.

Such outcomes suggest labour markets are very tight even if that is yet to be reflected in the WPI numbers yesterday. That would seem to validate anecdotes of a very tight labour market. And as mentioned, the forward indicators of the labour market remain strong. Accelerating wages can’t be far away if they are not already here.

A difficult time for the Bank of England (BoE), strong labour market data and strong inflation data, BoE appears to prevaricate on appropriate course

UK labour market data slightly better; A large inflation problem looms

Data released in the UK this week appear to raise the stakes for a BoE that seems reluctant to embrace a clear inflation-fighting stance. On the surface the labour market appears in robust health. Employment was much stronger than expected, the unemployment rate is approaching levels last seen in the early ‘70s. Unsurprisingly, and in contrast to the picture painted by the Australian WPI, average earnings (including bonuses) grew by 7.0% in March confounding at least temporarily expectations of a tight squeeze on household income. However, the picture was complicated by a sharp increase in annual inflation in April with the headline coming in at 9.0% yoy (core was a more modest 6.2%).

BoE Governor Bailey defends approach

Earlier this week, BoE Governor Bailey defended the BoE against charges that the Bank had been slow to respond to inflation challenges. He asserted that price increases were almost exclusively driven by supply shocks that couldn’t have been anticipated and that in any case it was “well established practice to accommodate supply shocks where they’re expected to be transient.”

In my view the comments are at the very least contestable:

  • The BoE (like other central banks) misjudged the persistence magnitude and momentum in inflation.
  • In its assertion that price pressures were exclusively “supply driven” the BoE downplayed the impact that its own extremely accommodative monetary stance had on inflation. This was a point made by former BoE Governor Mervyn King who claimed all developed central banks had kept monetary policy too loose for too long.
  • BoE communication has been inconsistent seeming to swing between the need to adjust policy to meet the inflation threat and denying a pressing need to tighten policy in a probably misguided attempt to influence market pricing of likely policy rate increases.
  • Finally, it is not “well established practice to accommodate supply shocks”. The notion of transitory inflation is that it doesn’t change wage and price setting behaviour. But there has been evidence for some time that these behaviours are changing. Even if it cannot influence supply levers in the economy, by failing to incorporate supply shocks in its monetary policy framework, central banks can magnify and perpetuate the inflationary damage such shocks can inflict. This is a key lesson from the 1970s.

Can the BoE chart a path between getting inflation back toward target without tipping the economy into recession?

At its last meeting the BoE stated that “some tightening of monetary policy might (my emphasis) be necessary”. This was thought to give the BoE the option to pause the tightening process at some stage. It had previously described tightening as “likely”. More recently BoE Governor Bailey noted that the BoE was, “walking a very tight line between tackling inflation and the output effects of the real income shock and the risk that that could create a recession and push us too far down in terms of inflation.” That statement indicates a reluctance to follow the Fed into a more aggressive stance.

But as is the case elsewhere, the BoE faces what looks like an increasingly intractable inflation problem and the more it prevaricates on addressing that problem now, the greater the possibility that the risks of a deeper recession down the track. Having let inflationary expectations escape the realm of being within their ability to comfortably manage without a serious risk of a substantial growth dislocation, it finds itself in the realm of “least bad” approaches. Similar to the Fed, the BoE remains engaged in charting a path between getting inflation back toward target without tipping the economy into recession. I remarked last week that in the case of the Fed, the portents on that front are not good. An inconsistency in its communication gives even less cause for optimism when it comes to the BoE.

In comments that arguably further confuse markets about the BoE’s approach, Bailey this week by admitted he felt “helpless” in the face of global price pressures, warning of an “apocalyptic” surge in the cost of food. He added that he has “run out of horsemen” after the pandemic and the war in Ukraine.

My view is that by seeking to douse market expectations that the policy rate will be higher than 2% by year-end is unnecessary. BoE communication has already proved a difficult beast to fathom and in the current circumstances the maintenance of maximum flexibility is a more judicious path than one that seeks to unnecessarily influence market pricing. Indeed that was the mistake that the RBA made toward the end of 2021. As in other developed countries, CPI inflation is at multi-decade highs and shows little sign of abatement. In that context, to presage a ‘pause’ now would seem inadvisable and compound the risks of the inflation genie getting out of the bottle (if it is not already so!).

Sterling weakness complicates the picture

While the USD has appreciated sharply this year against most other currencies, sterling has had its own particular challenges. That has been complicated by the results of the Northern Irish Assembly elections a couple of weeks ago which saw Sinn Fein emerge as the single biggest party in the Stormont. That has set in motion doubts about the durability of the UK / EU trade agreement on the Irish border and seen more pressure on sterling. Of course, that may assist the BoE in meeting any activity headwinds but complicates the inflation picture, possibly presaging at some stage a requirement for an even higher policy interest rate.

Canada CPI surprises on the upside

In what has become a depressingly familiar occurrence in developed country economies, Canadian April CPI exceeded expectations with the headline rate coming in at 6.8% yoy and core at 5.7% yoy (versus expectations of 6.7% and 5.7% respectively).

When it last met on April 13,  the Bank of Canada announced a 50bp increase in its policy rate to 1.00%. Further, the Bank indicated a disposition to further raise the policy rate throughout 2022 with Governor Macklem saying he expects rates will return to what they consider the “neutral range” of 2% and 3%, with policy makers prepared to move “forcefully” if needed. The April CPI numbers presage another “forceful” 50bp move when the bank of Canada meets on June 1st.

Such a policy action would mark an acceleration of what’s already an aggressive monetary tightening campaign.

By Stephen Miller, investment strategist 

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