US August inflation surprises on the upside and the RBA’s policy rate increment unlikely as domestic inflation remains sticky

Stephen Miller

US August inflation surprised on the upside. ‘Headline’ inflation came in at 8.3 per cent (versus 8.1 per cent expected) while ‘core’ inflation registered 6.3 per cent (versus 6.1 per cent expected). Rather than herald the much vaunted peak in inflation, last night’s release suggests core inflation has plateaued at elevated levels.

Disconcertingly, the strength in core inflation was led by the service sector where inflation is typically led by wage inflation. In some sense that should not surprise given the ongoing tightness in the US labour market.

Last night’s release reaffirms the rationale behind the hawkish tack from the Fed in the face of episodic market optimism of a “pivot” to a less aggressive stance.

That episodic optimism on the part of US financial markets can perhaps be better cast as episodic complacency, and it may well give pause to those in domestic markets looking for an imminent “pivot” from the RBA to lower policy rate increments.

What remains troubling and what will continue to focus the minds of the Fed and financial markets, if the latter are able to shake off a proclivity toward complacency, is the continued strong momentum in ‘underlying’ measures of inflation.

Measures of the ‘underlying’ inflation pulse continue to show extraordinary momentum and no meaningful evidence of retreat from historically high levels. On a 3-month annualised basis, the Cleveland Fed measure of median and trimmed-mean inflation are running at 8.3 per cent and 7.7 per cent respectively.

Such readings should put paid to the notion that inflation reflects just a few outsized price increases in selected commodities or ongoing supply chain blockages. 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.

Of course, for the Fed the key issue is not whether inflation has peaked (elusive as that peak has proven to be) but how quickly it gets back to something below 3 per cent.

Last night’s release cements the likelihood of a 75 basis point increment in the policy rate when the Fed’s FOMC meets next week.

Markets are now pricing a peak policy rate of around 4.30 per cent in the second quarter of 2023 with easing thereafter to under 4.00 per cent by end-2023.

With a peak policy rate above 4 per cent, market pricing now looks more in line with the Fed’s trajectory.

It may be that bond yields still have a little upside, and in my view may well end up close to a “4 handle”.

RBA: market hares running toward the inflation hounds. Imminent step-down in policy rate increment unlikely as domestic inflation remains “sticky”

RBA Governor Philip Lowe got the market hares running with last week’s speech to the Anika Foundation.

As part of an ongoing obsession with spotting a RBA pivot, the market commentariat trumpeted that the RBA was about to imminently reduce the monthly policy rate increment to 25 basis points. This after a reference to a couple of unremarkable notions that monetary policy operates with a lag and that the case for a slower pace of increase in interest rates becomes stronger as the level of the cash rate rises.

Investors should be wary of the commentariat punditry. After all, the pivot obsession has in the past led the commentariat to predict “eight of the last two pivots”!

It may be that markets have missed the key messages in Lowe’s address. That message is that RBA Board wishes to give itself maximum optionality when it comes to determining the size and timing of future policy rate increases and that incoming data will be the most important determinant of the future policy rate trajectory.  Hence Lowe’s carefully worded counsel that the RBA was “not on a pre-set path” when it came to future policy rate increments.

Given the current elevated level of uncertainty that attaches to both the domestic and global economic outlooks, that seems entirely appropriate.

Of course, that is not necessarily inconsistent with a step-down in monthly policy rate increases but nor does it any way make that eventuality any nearer than it might have appeared prior to the Lowe address.

After last year’s ill-fated guidance that the conditions for a policy rate increase “will not be met before 2024,” the last thing the Governor needs to do now is to appear to pre-commit to a policy path that is subject to the aforementioned uncertainty.

Some commentators have warned that given the lags in monetary policy there is a risk that the RBA may overdo it and plunge the economy into recession.

That is a risk, but so is a premature declaration of victory over the inflation threat.

It might be that too soon a reduction in the policy rate increment also runs the risk of letting the inflation genie run amok.

On that front, it is clear that higher frequency price and wage data continue to exhibit considerable momentum.

That what Lowe described as the “scourge” of inflation is a clear and present danger.

Tuesday’s release of the NAB Monthly Business Survey continued to exhibit troubling inflation portents for the September quarter and beyond.

Final product retail prices in the August survey increased at a quarterly rate of 3.3 per cent; the same record rate as was recorded in July.

Such momentum indicates a danger of the emergence of the 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.)

Moreover, it is suggestive of some upside risk to the most recent RBA trimmed-mean inflation forecast, issued just over a month ago, of a 6 per cent increase over the year to the December quarter 2022.

Investors should therefore regard any notion of a near-term RBA pivot with the maximum of caution.

It might well turn out to be yet another case of the market hares running toward the inflation hounds.

Another UK CPI: Surprises on the downside at “only” 9.9 per cent!

Finally, some good news on UK CPI inflation: it was “only” 9.9 per cent (versus an expected 40-year high of 10.2 per cent) and down from the 10.1 per cent recorded for July. The core measure came in as expected at 6.3 per cent, up from 6.2 per cent in June.

The narrative around high developed country inflation is well known – large increases in selected commodity prices and supply chain bottlenecks morphing into a more broad-based inflation, partially reflecting earlier central bank laxity.

The “good” August result notwithstanding, the Bank of England has been a conspicuous offender when it comes to central bank laxity. Brexit may be a contributor at the margin, largely reflecting an unwillingness on the part of the government to address some of the supply chain issues and labour shortage issues that have arisen as a consequence.

The Bank of England’s complicity result from its inability to articulate and execute a coherent strategy for dealing with the inflation.

Moreover, moves by the incoming Truss Government to cap household energy bills (funded by government borrowing) are likely to do little to curb the fundamental underlying inflation pressures.

The elevated ‘core’ reading is indicative of an inconvenient truth facing all developed country central banks; viz, that current inflation reflects more than just a few outsized price increases in selected commodities or ongoing supply chain blockages. Rather, it 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.

The essential primary task of a developed country central bank is to contain inflation. The Bank of England’s failure in this is more egregious than nearly all of its developed country counterparts (with the possible exception of the European Central Bank).

Like nearly every other developed country central bank, the Bank of England was tardy in recognising just how great a challenge inflation would prove for monetary policy. However, in my view not only was it lax in recognising the problem, it also has been lax (compared to other central banks) in attempting to rectify the consequences of its earlier policy missteps.

That some commentators lauded the Bank of England’s “analytical directness and intellectual honesty” when they “fearlessly” forecast a peak of 13 per cent in inflation this calendar year is a surprise to me.

Sure, the Bank of England may deserve marks for “fearless” forecasting – or “honesty” – but in my view it scores woefully (both relative to other central banks and outright) on the competence front.

Many central banks (the Federal Reserve, the Bank of Canada, the Reserve Bank of New Zealand, the Reserve Bank of Australia) appear to have learned (admittedly late in the piece) the lessons from 70s style inflation: viz, that any delay in articulating a coherent and firm response to an inflation threat only heightens the risks of more substantial macroeconomic dislocation down the track. It is not an easy task charting a course between vanquishing inflation without tipping the economy into recession. History is not replete with central banks executing that task successfully. However, the aforementioned at least gives themselves a shot at “second-best” outcomes.

Up until its last meeting on 4 August when it (finally and a little grudgingly) delivered a 50 basis point increment in the policy rate to 1.75 per cent, the Bank of England’s response, was to partly default to a more highly risky approach of letting a squeeze on real incomes become the “cure” for a diminishing of inflation. That involves a more elongated and painful approach than an expeditious shifting of policy rates to neutral levels and beyond. In so doing it (along with the European Central Bank) appears to have unwittingly opted for a “nth” best strategy. That approach risks the worst of both worlds – a vicious and lasting stagflationary environment (albeit one that is “honestly” forecast).

Moreover, Governor Bailey frequently gave the impression that he was unconvinced that the Bank of England had a frontline role to play in containing inflation.

The Bank of England has shifted to a more aggressive stance. Markets are currently contemplating a policy increment of either 50 basis points or 75 basis points when the Bank of England holds its (delayed) meeting next week.

There is a suggestion that the Government measures to cap energy bills give the Bank of England cover to only go 50 basis points. For the reasons outlined above, I think such an approach is flawed and prudence dictates the desirability of the higher increment. As mentioned, to do otherwise only heightens the risks of more substantial macroeconomic dislocation down the track.

Coming up: Australian July labour force

The Australian August labour force data to be released today are expected to reinforce the notion of likely ongoing tightness in labour market conditions. July’s release revealed the unemployment rate at a 48 year low of 3.4 per cent (even if employment fell some 41k). This followed June’s blockbuster numbers which showed an employment increase of 88.4k. The consensus expectations reported by Bloomberg are for an increase in employment of circa 35k and an unchanged unemployment rate at the 48 year low of 3.4 per cent.

That volatility exhibited in the June and July releases are indicative of a little statistical noise so there is some risk of a surprise print in July.

Regardless, it is difficult to argue against the proposition that labour markets are tight. Anecdotes of this abound and the NAB Monthly Business Survey released on Wednesday showed a buoyant labour market.

As discussed above with respect to troubling inflation portents, it is difficult to see this report being inconsistent with another 50 basis point policy rate increase from the RBA in October.