Stephen Miller
In what was somewhat of a surprise, the RBA joined a number of other developed country central banks in announcing a 50 bp policy rate increase at the conclusion of Tuesday’s RBA Board meeting.
In admitting my surprise, I am not being critical of the RBA action. More to the contrary I think it was entirely appropriate and could be well-framed as a reflection of the lessons learned from the travails of other developed country central banks: that acting early after demonstrable inflation surprises is preferable to later. A failure to act now might occasion even more aggressive increases later with an attendant greater growth dislocation. This is the “stitch in time saves nine” approach to policy rate increases.
In this context Governor Lowe’s observation that “inflation is likely to be higher than was expected a month ago” was instructive. Just a month ago in its May Statement on Monetary Policy (SoMP), the RBA substantially revised its inflation forecast. That forecast had headline inflation peaking at close to 6 per cent by year-end and the RBA’s favoured trimmed-mean measure peaking at 4.6 per cent also at year-end.
As has been the case elsewhere, the RBA has been surprised (repeatedly) by the persistence, magnitude and momentum in inflation. It also appeared to downplay moderate wage increases exhibited in (dated) official releases, noting significant labour market tightness with the unemployment rate at 3.9 per cent being the lowest rate in almost 50 years and further that the RBA “business liaison program continues to point to a lift in wages growth from the low rates of recent years as firms compete for staff in a tight labour market”.
That suggests that its recently acquired hawkish stance looks set to continue and that a further 50 bp hike may come in July and August if inflation pressures intensify.
In my view that is not yet a certainty. For one thing the RBA meets monthly, as opposed to every 6 weeks like most of its developed country counterparts. That may afford it the opportunity to opt for a further 25 bp increase in July and the consider whether a 50 bp increment in August is appropriate once it sees the June quarter CPI released on 27 July. A 50: 25: 50 bp sequencing of rate rises over three consecutive meetings would be virtually equivalent to a 50:75 sequencing over two consecutive meetings in other developing country central banks. Should RBA and market inflation fears not intensify as currently expected a 50:25:25 sequencing could eventuate, which would be virtually equivalent to a 50:50 sequencing over two consecutive meetings elsewhere in the developed world
The RBA did note that the “Board expects to take further steps in the process of normalising monetary conditions in Australia over the months ahead” but that “the size and timing of future interest rate increases will be guided by the incoming data and the Board’s assessment of the outlook for inflation”.
Financial markets are pricing a policy rate close to 3 per cent by year-end rising to above 3.75 per cent by the second half of 2023. Even if at this stage the contemplation of a scenario that validates such pricing is certainly not implausible. It is a fine judgement, but the risks around that pricing are weighted toward it being “too much” rather than “too little” at this stage.
However, that depends heavily on the downwards trajectory of inflation post the forecast December peak.
ECB institutional inertia in decision-making renders it the “odd central bank out”
The European Central Bank (ECB) meets on Thursday evening amid signs of a fracturing of views among the ECB Governing Council concerning the rapidity and quantum of policy rate hikes.
In an era that has been characterised by laggard central banks, the ECB is the poster child when it comes to a failure to appreciate the persistence, magnitude and momentum of inflation.
European inflation numbers are immensely troubling. The May Harmonised Consumer Price Index (HCPI) came in at 8.1 per cent, four times the ECB’s 2 per cent goal.
This is from a central bank whose mission statement asserts that “price stability is the best contribution that monetary policy can make to economic growth.”
Europe faces a circumstance where the inflation genie looks well and truly out of the bottle and with an accompanying massive squeeze on real incomes, the threat of stagflation is a clear and present danger.
All central banks are in the process of attempting to execute a high wire act: charting a path between getting inflation back toward target without tipping the economy into recession.
ECB President Christine Lagarde is channelling her famous countryman, the tightrope walker Charles Blondin, as the ECB attempts the high wire act without a balancing pole and blindfolded.
It has demonstrated an egregious reluctance to engage in any meaningful shift in policy from “emergency” levels.
It will likely only announce the end of QE at Thursday’s meeting.
In other words at a time when most other developed country central banks have already commenced policy rate lift-off and have mostly decided that an accelerated path to neutral via policy rate increments of 50bps is the appropriate course, the ECB is still engaged in applying pandemic era “emergency” levels of monetary stimulus.
It is the case that Lagarde has recently abandoned her usual studied circumspection to foreshadow two 25bp increases in July and September. That is at meetings subsequent to Thursday’s one!
Even then she revealed a reluctance to acknowledge the depth of the inflation problem and continues to imply that it is more transitory in nature. Lagarde has asserted that the ECB was “facing a very different beast” to the Fed. That might be correct, but the May inflation numbers suggest that it might not be different in the way Lagarde sees it.
Indeed, Lagarde’s comments on July and September rate hikes did not seem to indicate a Damascene shift in view, but more an attempt to stave off growing calls among the ECB’s more hawkish wing and from markets to keep the option of a 50bp hike at either the July or September meetings.
Of course, Lagarde has a difficult job. The ECB is cursed with an institutional inertia in its decision-making that afflicts most pan-European institutions. That same institutional inertia severely constrained its ability to flexibly employ fiscal measures which might have taken some of the burden of monetary policy early in the pandemic. Witness also, the tortuous intra-European negotiations over Russian sanctions in the wake of the Ukraine invasion.
The calls for a 50bp increase are getting louder with concerns about the path for consumer prices becoming unanchored, requiring tougher measures later on that could trigger a an even more disruptive economic dislocation.
ECB meetings are about to get interesting – more interesting than usual – and Lagarde will need to harness all of her deft diplomatic skills and the authority she carries as the President to see her view prevail.
I have my doubts whether that view is the right one.
Coming up: US May CPI; Inflation is peaking but is it fast enough to see the Fed ease the brakes?
Given recent indications that US inflation has peaked markets will be casting a keen eye on Friday’s May US CPI release.
The Bloomberg consensus currently anticipates headline inflation unchanged at 8.3 per cent but a decline in core inflation from 6.2 per cent in April to 5.9 per cent. That implies a 3-month annualised core rate of inflation of 5.7 per cent the same as in April but down from the 7.0 per cent recorded in December.
Such an outcome might be good news in the sense that it would reinforce the notion that the peak in inflation pressures is behind us but it would also underscore the stubborn nature of the inflation challenge.
In that sense the fall in core inflation is nowhere near enough to take the pressure off the Fed and it remains the case that 50 bp increments in the policy rate are likely at the June and July meetings and perhaps beyond.
The Fed has recently been aggressive in articulating its determination to vanquish inflation.
Financial markets are currently implying a nominal policy rate around 2.75 per cent by year-end and around 3.25 per cent by mid-2023.
Even on the extremely benign assumption of an inflation rate returning to a ‘steady state’ 2.5 per cent 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 than markets are currently pricing in order to achieve such an inflation outcome.
If, as looks more likely, inflation is “sticky” and declines only grudgingly toward 3 per cent those real policy rate levels start to look too low.
In the same context I do note see the Fed being disturbed by bond yields well in excess of 3 per cent.
Some recent market commentary has suggested that the Fed may lighten up on its aggression as confidence grows that inflation is at a peak and increasing bond yields put equity markets under renewed pressure.
My view is that such an expectation is at best premature and at worst misplaced.
For one thing the Fed put still looks well out of the money.
For another, real bond yields – both trailing and prospective – are still very low in a historical context. In a period of stubbornly high inflation it is not clear that the current level of real bond yields is anywhere near sufficiently restraining. For example a return to the 2017-19 average “trailing” real yield of around 0.50 per cent with inflation sticky at 3 per cent 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 per cent.
Updates in these measures that will also be released with the May CPI will therefore be closely watched. Again, a decline is expected but only a grudging one.
That being the case it is not implausible that the Fed 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.
By Stephen Miller, investment strategist
