Stephen Miller

A little surprisingly in my view the Reserve Bank of Australia (RBA) Board meeting today decided on a downshift in the size of the policy increment from 50 basis points to 25 basis points. Today’s move took the policy rate to 2.60 per cent from 2.35 per cent.

In opting for a 25 basis point increment the RBA Governor in his Statement following the meeting cited two key factors.

The first was growing uncertainty in the outlook for the global economy which it described as having “deteriorated recently”.

The second was how household spending in Australia responds to the tighter financial conditions. The implication being that the RBA Board would like to gauge the full effects of higher interest rates on household spending.

The Governor’s Statement appeared to indicate that the difference between 25 basis point and 50 basis point was a fine judgement and while a surprise to many, including this writer, the Board decision is certainly defensible.

The Statement reiterates that “the Board expects to increase interest rates further over the period ahead” and further that it “remains resolute in its determination to return inflation to target and will do what is necessary to achieve that.” In other words, the Governor was keen to signal that the Board remains vigilant and has not taken its eye off the (inflation) ball.

Further, the greater frequency of RBA Board meetings compared with their counterparts elsewhere may have afforded the opportunity of lesser 25 basis point increment in October. The RBA meets monthly, as opposed to every 6 weeks like most of its developed country counterparts. A 50: 50: 25 basis point sequencing of rate rises over three consecutive meetings would be virtually equivalent to a 50:75 sequencing over two consecutive meetings in other developed country central banks.

However, while acknowledging that the downshift may have been a fine judgement, and is certainly defensible, the Board may have opened itself up to some “awkward optics” if the extraordinary momentum in high-frequency price and wage measures show up in an outsize increase in the September quarter Consumer Price Index (CPI), forcing the RBA back to a 50 basis point increment in November.

Even then, there is nothing intrinsically wrong with upping the increment should circumstances dictate.

As the Governor noted in his Statement, the path to returning inflation to the 2-3 per cent target and keeping the economy on an even keel “is a narrow one and it is clouded in uncertainty.” It is arguably appropriate that given the global outlook, and given the lags in monetary policy effectiveness, that the RBA exercise a little caution to mitigate the risk of recession.

But just as recession is a risk, so is a premature declaration of victory over the inflation threat.

On that front the newly minted Australian Bureau of Statistics monthly inflation indicator, and price and wage data from the NAB Monthly Business Survey, point to the risk of a sizeable increase in the RBA’s favoured trimmed-mean measure of inflation.

NAB economists are expecting an outcome for trimmed-mean inflation of around 1.6 per cent for the September quarter (albeit that ex-ante, the distribution of potential outcomes is particularly wide this time around). That is not inconsistent with the RBA forecast of 6 per cent by year-end but in my view, given anecdotes on wage growth, there is some small upside risk to that forecast.

The momentum in the high frequency data indicate 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.)

In this context, the RBA Board might be grateful with “awkward optics” to be the extent of its challenges over the coming period.

Reserve Bank of New Zealand (RBNZ) increases 50 basis points

Meanwhile, across the Tasman, central bankers are either made of sterner stuff or are less nuanced.

Seemingly undaunted by the same “uncertainties” weighing on the RBA, the RBNZ, as was anticipated, raised the policy (official cash rate (OCR)) rate by 50 basis points to 3.50 per cent with indications of a similar size increase when it meets again in November.

Moreover, in stark contrast to their trans-Tasman cousin, the RBNZ revealed that it considered hiking the benchmark by 75 basis points, with some members arguing “that a larger increase in the OCR now would reduce the likelihood of a higher peak in the OCR being required,” before opting for 50 basis points.

In announcing today’s move, the RBNZ noted that the “the Committee agreed it remains appropriate to continue to tighten monetary conditions at pace,” and further that “core consumer price inflation is too high.”

The bank didn’t make any reference to its most recent projections in August, which showed the benchmark rate rising to an average 4.1 per cent early next year although the tone of the RBNZ Statement has led market commentators to ponder a terminal rate much higher than that.

US bond yields: a turning point, a plateau or more hill to climb? All eyes on September non-farm payrolls report on Friday

Not unexpectedly, US activity data appears to be responding to the Federal Reserve (Fed) policy rate hikes and the recent hawkish comments from Fed officials following Chairman Powell’s comments at the Jackson Hole Symposium.

Market pricing of the policy rate also appears more aligned with that Fed communication suggesting a peak close to 4.5 per cent in the first half of 2023, even if the current Fed “dot plot” suggests a slightly higher peak.

The 10-year bond yield also appears to have reflected the vigour of Fed communication.

That begs the question as to whether bond yields are at a turning point.

I suspect that rather than a turning point, the 10-year bond yield will plateau in the 3.50-4.00 per cent range. A suspicion that 10-year yields are a little too optimistic on the rapidity with which inflation can get back to around 2.5 per cent would mean that upside risks remain. But in any case, the bulk of the cyclical move upwards in yields would now seem to be behind us.

Labour market and inflation data will determine the veracity of that view.

As is well known, the US monthly non-farm payrolls report is keenly watched. This Friday sees the release of the September report which takes on a special poignance. Markets will be particularly exercised on the extent to which the report reflects any tempering of activity growth and wage pressure.

The resilience in the US labour market has been a key factor in allowing the Fed to pursue a particularly aggressive tilt in its recent communication. Any significant weakness in the labour market and any attendant deceleration of wage growth may see markets question the durability of the Fed’s hawkish stance, perhaps presaging a downshift in the policy rate increment to 50 basis points at the next Fed meeting on 1 -2 November.

Recent indications on the labour market, while not suggestive of a sharp softening in labour market conditions, have nevertheless been a bit more mixed.

The July Job Openings and Labor Turnover Survey (JOLTS) report released earlier in the week revealed a sharp drop in job openings, albeit from a high base to its lowest level since June 2021. Fed Chairman Powell has in the past put some emphasis on the job openings-to-unemployed ratio which fell from 1.97 (almost two job openings per unemployed person) to 1.67 in August.  That is still consistent with a very tight labour market but the signs of easing demand for labour are clear.

The Institute for Supply Management (ISM) Purchasing Manager Index for Manufacturing (PMI) showed markedly weaker employment conditions. The employment index within manufacturing fell sharply from 54.2 in August to 48.7 in September. However, last night’s September Services PMI showed an unexpected rise in the employment component up to 53.0 from 50.2 in August.

The revamped ADP measure showed a satisfactory 208k increase in employment in September, although the prior measures were never a great guide to the Bureau of Labor Statistics report.

According to Bloomberg, market expectations for US September non-farm payrolls are for an increase in employment of around 250k (from 315k in August). My view is that is a satisfactory outcome, at least as far as labour market resilience is concerned. The unemployment rate is expected to be unchanged at 3.7 per cent, which while off the trough of the 50-year low of 3.5 per cent recorded in July, is still indicative of a tight labour market.

The average earnings (wages) number within the overall non-farm payrolls report will again be closely scrutinised, with the market expecting an annual increase around 5.1 per cent from 5.2 per cent in August.

In my view the balance of risks on these expectations is for a softer report. Having said that, the more significant data release for yields will be in next Thursday’s September CPI report.

The price index within the Manufacturing ISM has retreated sharply from the 2022 high in March to be now at 51.7 from 52.5 in August and a whopping 87.1 back in March in the wake of Russia’s invasion of Ukraine. However, the services prices component, which is probably a better guide to the breadth of inflation pressures, remains in extremely elevated territory at 68.7.

Measures of the ‘underlying’ inflation pulse continues to show extraordinary momentum with 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 – in the case of the former, at a four-decade high, and in the case of the latter only a little off that four decade high. The same measure of the Dallas Fed trimmed-mean Personal Consumption Expenditures (PCE) price index is at 5.6 per cent, also at a four-decade high.

It will take a visible turning point in these inflation series for bond yields to meaningfully fall.

In some sense any stabilisation in bond yields might represent good news for equity markets, representing as it does, the abatement of what has been a significant valuation headwind. However, even if equities have priced the reality of higher bond yields, consensus earnings per share (EPS) forecasts are priced at the optimistic end of the likely cyclical downside. In other words, were bond yields to stabilise or even fall that might not be sufficient to elicit any meaningful rebound in equity markets.

By Stephen Miller, investment strategist 

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