Stephen Miller

Federal Open Markets Committee minutes underscore The US Federal Reserve’s aggression

Prior to the release overnight of the Fed’s Federal Open Markets Committee (FOMC) meeting minutes there had been some market commentary that US 10-year yields may have seen a cyclical peak and that attendant upon that the USD might also have seen a cyclical peak.

Some of that commentary stems from a view that  inflation might have peaked and that fears of ‘70s style inflation (or stagflation) are overblown. That might well be true, but it is far from axiomatic that as a result bond yields have seen a cyclical peak.

No one is seriously expecting a precise replay of the ‘70s. In my view the real risk is if a “’70s lite” occurrence that would still imply 10-year bond yields well in excess of 3% and with it a still higher USD.

While the Fed has been very aggressive in articulating its determination to vanquish the current inflation surge, it has potentially allowed inflationary expectations to 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. Companies feel more confident to increase prices because prices are going up everywhere while workers are naturally seeking higher wages, particularly in those areas of the economy where skill shortages are acute. These phenomena are easily observable today.

These effects might be under-appreciated by financial markets. So while financial market expectations of inflation have receded somewhat from their peak, that may be of little comfort. Both central banks and markets have had a pretty dismal record in forecasting inflation of late. In the ‘70s too, bond markets took some time to awaken to the new (higher) inflation realities.

On the basis of the minutes from the Fed’s May FOMC meeting the Fed is not currently burdened by similar anxieties regarding overblown inflation concerns.

Those minutes revealed a Fed focussed on the requirement to raise interest rates quickly and possibly more than markets anticipate to tackle a burgeoning inflation problem.

The minutes said that “most participants judged that 50 basis point increases in the target range would likely be appropriate at the next couple of meetings,” and further that FOMC members indicated that “a restrictive stance of policy may well become appropriate depending on the evolving economic outlook and the risks to the outlook.”

That is a strong suggestion that the Fed plans 50bp moves at its next couple of meetings in June and July and that policy may have to move past a “neutral” stance to a point where policy becomes restrictive.

So even if inflation has peaked, it is probably not enough to take the pressure off the Fed and nor is likely to be enough to take the pressure off bond yields.

Nor do I see the Fed being disturbed by bond yields rising well above 3%.

Some market commentary this week suggested that the Fed may lighten up on its aggression as equity markets tumbled. That is curious in a market that is up around 16% pa in the last 3 years, the pandemic and Ukraine conflict notwithstanding. When viewed through that prism the ubiquitous ‘Fed put’ is still well out of the money. For a Fed to start getting anxious about its articulated roadmap because of likely equity market performance looks fanciful in that context.

Real bond yields – both trailing and prospective – are not that far from historic lows. In a period of rising inflation it is not clear that the current level of real bond yields is anywhere near sufficiently restraining. The same might be said of current market expectations of the policy rate. Markets currently have the Fed Funds rate at just above 2.50% by year-end and peaking just above 3% in the second half of 2023.

Even on the very benign assumption of an inflation rate returning to a ‘steady state’ 2.5% in a year or two, implied real Fed Funds rates are far from restrictive levels. This suggests that the actual policy rate may need to increase further to achieve such an inflation outcome.

If, as looks more likely, inflation is “sticky” and declines only grudgingly toward 3% those real policy rate levels start to look too low.

Real 10-year bond yields below 3% also look too low.

For example a return to the 2017-19 average “trailing” real yield of around 0.50% with inflation sticky at 3%, or perhaps a little above, implies a nominal 10-year yield reaching the mid to high 3s. Even then one might argue that such a real yield is barely restrictive.

And 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 stubbornly elevated inflation. Such 3-month annualised measures of the ‘inflation pulse’ are well above 6%.

Therefore, despite an apparent peak in core inflation therefore it is not clear that the Fed will think its job is done and it may well wish to engineer even higher levels of bond yields and may need to do so by taking the Fed funds rate higher than markets currently anticipate.

European Central Bank foreshadows policy rate increases. Is the EUR surge overdone?

In a shift from her usual studied circumspection, ECB President Christine Lagarde’s blog post^[1] on Monday signalled her view of what the withdrawal of monetary stimulus  in Europe may look like. Lagarde outlined a timetable whereby the ECB at its next meeting on 9 June formally announces the end of its QE program after the completion of those asset purchases already scheduled for June followed by two 25bp increases in July and September.

A little surprisingly in my view, Lagarde’s comments seemed to ignite a strong rally in the EUR. Lagarde’s comments were certainly not an indication of a more aggressive path than that anticipated by the market and appeared to represent an attempt to stave off growing calls among the ECB’s more hawkish wing to keep the option of a 50bp hike at either the July or September meetings on the table.

In a follow-up Bloomberg interview Lagarde maintained that the inflation shock hitting the Euro region isn’t demand-driven, which she maintained implied a requirement for a more gradual approach than that undertaken by say the Fed. Lagarde maintained that the circumstance in Europe was one where “inflation is fuelled by the supply side of the economy” and that accordingly that the ECB “doesn’t have to rush”.

The comments are somewhat at odds with other ECB Council members who favour keeping the option of a 50bp increase on the table. Three policy makers have canvassed keeping open the option of a 50 bp move. Dutch central bank governor Klaas Knot currently favours a 25bp hike but was willing to contemplate a 50bp increase if the inflation outlook worsens. Latvia’s Martins Kazaks and Austria’s Robert Holzmann have made similar comments.

A fourth council member, Bundesbank President has pointed to “disturbing evidence that the increase in inflation is gaining momentum”. More consumers and companies expect prices to keep rising rapidly, which meant “the risk of acting too late is increasing notably.”

For the time being it seems likely that Lagarde will prevail given her deft diplomatic skills and the authority she carries as the President, not to mention that the majority of Council members appear to line up with her view.

That makes the pop in the EUR look overdone in my mind.

But I remain unconvinced that differences between the inflation circumstances confronting the US and those in Europe are sufficiently different to warrant the extent of the moderation in approach from the ECB.

Inflation expectations have a habit of being self-fulfilling through their effect on wage and price setting behaviour. 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.

Moreover there are other elements at work with European inflation, not the least of which is the historically high levels of monetary accommodation from the ECB itself. Ongoing structural shifts in the labour market associated with peak baby boomer participation and slowing skilled migration flows that have previously supressed wage growth are also important, as is the turning political tide against globalisation.

These are key challenges for a central bank such as the ECB which is facing record inflation which at 7.5% is almost four times the ECB’s 2% goal.

It is an inconvenient truth that the ECB is cursed with an institutional inertia in its decision-making processes.

Were that inertia to manifest itself in too gradual a withdrawal of monetary stimulus, a weaker EUR trend might be expected to re-emerge.

Reserve Bank of New Zealand raises the policy rate for the fourth time this cycle

Proving itself one again as among the more aggressive of developed country central banks in meeting the current inflation challenge, the RBNZ raised the policy rate (Official Cash Rate or OCR) by 50 bps to 2.00%. Yesterday’s move is the first time New Zealand’s central bank has delivered consecutive 50 basis-point increases since the OCR was introduced in 1999, and takes its tightening since October to 175 basis points.

The RBNZ underscored its hawkish credentials by signalling an even more aggressive path than that foreshadowed back in February. It now expects the cash rate to peak at close to 4% in the third quarter of 2023. In February the RBNZ had forecast a peak of 3.35% in 2024. However, the new track shows the OCR starting to gradually decline from the second quarter of 2024.

In a statement that accompanied the announced increase, the RBNZ  said that the Monetary Policy Committee “is resolute in its commitment to ensure consumer price inflation returns to within the 1-3% target.” It added that the “Committee agreed to continue to lift the OCR at pace to a level that will confidently bring consumer price inflation to within the target range.”

The Statement appeared to imply that current RBNZ thinking is for a further 50bp increment when it next meets on July 13th and likely reverting to 25bp increments thereafter.

Limited portents for the Reserve Bank of Australia (RBA) – for the time being.

There are limited portents for the RBA even given some convergence of approach in recent month as the RBA pivoted toward a more hawkish stance. Last week’s Wage Price Index(WPI) substantially eased any pressure on the RBA for ‘supersized’ increases. Having said that the numbers are not enough to forestall a further increase of 25bps in the policy rate when the RBA meets on 7 June.

There have been a number of other indications that wage growth is accelerating. According to the WPI release average wage increases during the March quarter 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. Industry surveys are also showing accelerating wage increases with the most recent March quarter NAB business survey showing labour costs increased 2.7%, well above the previous 2% record reached more than 15 years before. The focus will switch to 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 may rekindle expectations of a “supersized’ increase down the track, particularly if inflation again surprises on the upside.

Last week’s labour force numbers showed the unemployment rate at 3.9%, the lowest in 48 years. Such an outcome suggest labour markets are very tight . All that suggests that accelerating wages can’t be far away, if they are not already here.

In the final analysis, however, the market’s expectation of a policy rate close to 2.50% by year-end indicates a more aggressive RBA than one indicated either by the data or the RBA’s own communication.

By Stephen Miller, investment strategist

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[1] Monetary policy normalisation in the euro area

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