Stephen Miller

US ‘headline’ inflation peaks. Will the Fed ease the brakes?

In what was somewhat of a surprise, July US inflation surprised on the downside.

In headline terms, the US CPI inflation rate looks to have peaked and is in retreat from 40-year highs. July headline inflation came in at 8.5 per cent, versus 8.7 per cent as expected, and down from 9.1 per cent in June.

Core inflation also surprised on the downside coming in at 5.9 per cent, the same as in June, but lower than the 6.1 per cent expected.

That is clearly a positive result and excited expectations of a lower cyclical peak in the policy rate.

While undeniably good news for markets, it would have been catastrophic had there not been some retreat from the June high given the substantial decline in oil prices since then.

Moreover, while core inflation came in better than expected, it remains at elevated levels.

And for the US Federal Reserve (the Fed), the key issue is not whether inflation has peaked but how quickly it gets back to something below 3 per cent.

But for the time being markets have lowered expectations for the Fed’s policy increment at the next meeting in September.

Prior to the release of the July CPI report, financial markets were leaning heavily toward a 75 basis point (bp) increment for September. That now looks more skewed toward 50 bps.

Markets were also pricing a peak policy rate of around 3.70 per cent early in 2023 with easing thereafter to around 3.20 per cent by end-2023. Now markets are pricing a peak policy rate around 3.60 per cent, again by early 2023, declining to around 3.00 per cent by end-2023.

That looks somewhat optimistic in my view.

What remains troubling and what will continue to focus the minds of the Fed is the continued strong momentum in ‘underlying’ measures of inflation.

Measures of the ‘underlying’ inflation pulse continue to show extraordinary momentum and no retreat from the historically high levels recorded in June. On a three-month annualised basis, the Cleveland Fed measure of trimmed-mean inflation continued to run at 8.4 per cent, the same as June.

Such readings suggest that inflation is more than just a few outsized price increases in selected commodities or ongoing supply chain blockages and that any retreat will be smooth as those influences unwind. Rather, that sort of inflation pulse is indicative of an inflation inertia (last seen in the late ‘70s / early ‘80s) that may yet prove a lot more difficult to arrest than markets are currently contemplating.

In that sense the July CPI report might ease the pressure on the Fed but it doesn’t take it off entirely.

Current pricing for the Fed therefore is not implausible, but in my mind is located at the very benign end of the risk continuum.

Current market-based expectations of inflation are for it to fall to around 3 per cent within two years. That implies that the (trailing) real policy rate struggles to get above zero. That looks to be some way from the “restrictive” levels the Fed judges to be necessary to contain inflation. Even more so if, as seems to be the case, inflation is “sticky” and declines only grudgingly toward 3 per cent.

The forgoing to me implies that the nominal policy rate may need to go higher than markets currently contemplate.

Were the more benign developments evident in the July CPI report to be repeated in the August report, which is released prior to the next Fed policy meeting, and were we to see some turn in those ‘underlying’ Cleveland Fed measures, current expectations would become that much more plausible and the more troubling scenario I have canvassed less so.

Inflation news not so good for RBA. NAB Monthly Business Survey shows extraordinary price pressures

Unlike the US, recent inflation news flow in Australia has not been as comforting.

The Australian June quarter CPI ‘headline’ number, at 6.1 per cent, may have been (ever so slightly) better than expectations, but it was the highest annual read since December 1990.

The annual rate of change in the Reserve Bank of Australia’s (RBA’s) favoured trimmed mean measure, at 4.9 per cent, was the highest since the inception of that series in June 2003, and (using prior measures of ‘underlying’ inflation) the highest ‘underlying’ measure since the early ‘90s.

Since that release there have been several indications of that strong inflation momentum extending into the September quarter.

According to the Melbourne Institute’s monthly inflation gauge, price increases continued to increase in July at the fastest pace in over two decades.

The NAB July Monthly Business Survey showed extraordinary momentum in wage and price indicators in July. Retail prices in the July survey increased at a quarterly rate of 3.3 per cent, while labour costs and business purchase costs were up by a whopping 4.6 per cent and 5.4 per cent respectively.

That cocktail of price measures is indicative of the same sort of inflation inertia that was last experienced on a global scale in the late ‘70s / early ‘80s (it lasted a little longer in Australia).

Like the US, it may prove a lot more difficult to arrest than markets are currently contemplating.

Certainly, if the RBA is in receipt of the same information contained in the NAB survey, then a 50bp increment in the policy rate must be on the agenda for the September and October meetings and, if confirmed by the September quarter CPI release on 26 October, perhaps the November meeting as well.

Were such increases followed by a 25bp increment in December, that would mean the cash rate ends the year at around 3.60 per cent compared with a market expectation of around 3.20 per cent.

Like almost every other central bank, a late start, and an overly conservative approach to the withdrawal of historically high levels on monetary stimulus has put the RBA beyond the realm of “first best” solutions.

It now finds itself searching for a “least bad” or a “second best” outcome.

However, if there was a lesson to be learnt from the 1970s inflation episode, it is that a more tepid approach now might necessitate an even more aggressive approach down the track with an attendant greater likelihood of more substantial macroeconomic dislocation in terms of growth and employment.

In this context, if the current policy rate is indeed well below the neutral rate and there is a pressing requirement to get to neutral and maybe beyond that to “restrictive” territory, then the best approach is to do so as quickly as possible.

If the sort of measures contained in the July NAB Survey were to persist, and the inflation challenge is accordingly even greater – and there is certainly some scope for debate around that – then another cumulative 175bps increase in the policy rate between now and year-end would certainly go a long way to the containment of inflation and importantly inflation expectations, both in financial markets and among important economic actors.

It seems a long wait now until the next CPI release on 26 October.

In this context, monthly price indicators from the NAB Survey and the Melbourne Institute assume a greater importance in terms of their implications for policy and markets.

In a timely development, the Australian Bureau of Statistics yesterday announced that it plans to release an Information Paper outlining the new monthly CPI Indicator on 16 August, and to publish the first standalone monthly CPI Indicator publication in October, alongside the regular quarterly CPI release.

Such a measure can’t come soon enough.

The post Inflation news not good for the RBA as US “headline’ inflation peaks appeared first on AdviserVoice.