A tale of two central banks and Australian labour force data expected to show continued tight labour market conditions

Stephen Miller

A tale of two central banks

The Federal Reserve (Fed)

Last week’s release of the US October consumer price index (CPI) and this week’s release of the US October producer price index (PPI) potentially represent a huge vindication of the aggressive approach exhibited by the Federal Reserve to the containment of inflation. The Fed has raised the policy rate by 375 basis points since March, including four successive 75 basis point policy rate increases since June.

Certainly, the initial judgement from financial markets would appear to endorse the Fed’s approach.

Bond yields have fallen sharply, and equity markets have rallied. Meanwhile markets scaled back their expectations for the peak in the Fed funds rate to around 4.90 per cent from around 5.10 per cent just a week ago after the November FOMC meeting.

Of course, as the saying goes, “one swallow doesn’t make a summer,” but the details in the release suggest that not only has inflation peaked, but it may well have passed a turning point.

Measures of the ‘inflation pulse’ are showing significant deceleration. The 3-month annualised core CPI declined to 5.8 per cent after peaking at 7.9 per cent in June. Similarly, the Cleveland Fed trimmed-mean measure declined to 6.4 per cent from a peak of 8.4 per cent in June.

The big question regarding future inflation is over the trajectory of services inflation. On that front the jury is still out.  The 3-month annualised rate is running at 7.8 per cent up from 7.5 per cent in September but down from the peak of 9.9 per cent recorded in June. There are, however, grounds for cautious optimism given recent modest declines in annual wage growth evident in the non-farm payrolls data.

Probably reflecting some “stickiness” in services inflation, Federal Reserve officials, while quick to welcome the inflation news, warned that increases in the policy rate were required to complete the battle against inflation.

The Fed approach has come in for some reasonably pointed criticism from elements of the market commentariat and from both sides of politics. Through much of 2022, after the Fed’s embrace of an aggressive inflation containment approach, the critics charged that the Fed was consigning the US to an inevitable and unnecessary recession.

In my view those critics failed to learn the lessons from the ‘70s and the policy mistakes from the Fed under the leadership of Arthur Burns and G. William Miller, whose excessive caution wrought the (necessary) aggression of the Volcker era. The lesson here is that any delay in articulating a coherent and firm response to an inflation threat only heightens the risks down of a more damaging macroeconomic dislocation in terms of employment and activity down the track.

As chairman Powell stated during his press conference post the most recent FOMC meeting:

“…if we over tighten…then we have the ability with our tools, which are powerful, to, as we showed at the beginning of the pandemic episode, we can support economic activity strongly if that happens… On the other hand, if you make the mistake in the other direction, and you let this drag on, then it’s a year or two down the road and you’re realizing inflation behaving the way it can, …then the risk really is that it has become entrenched in people’s thinking and the record is that the employment costs, the cost to the people that we don’t want to hurt, they go up with the passage of time…” (my emphasis)

There is light at the end of the tunnel for US financial assets. The decline in bond yields might represent good news for equity markets, representing as it does the abatement of what has been a significant valuation headwind. And while equities may soon reflect the prospect of lower bond yields, the question remains whether earnings estimates have priced the likely cyclical downside. Even on that front the resilience of the US economy and labour market is encouraging. After the release overnight of stronger than expected retail sales data for November, the Atlanta Fed ‘GDPNow’ estimate for Q4 is currently running at 4.4 per cent.

All said and done, the Fed can afford to approach 2023 with some guarded optimism that its aggressive policy of inflation containment through 2022 is on course to achieve its objectives without an excessive dislocation in terms of activity and employment.

The Reserve Bank of Australia (RBA)

Which brings me to the RBA.

First, and on a positive note, the release of the minutes from the November meeting indicate that the RBA has learnt the lessons from its communication missteps through 2021 and into 2022. It has also clearly sought to nuance its communication by acknowledging the fat tails that attach to its inflation forecasts and the attendant requirement for the RBA to communicate maximum optionality when it comes to adjustment of the monetary policy dials should that become necessary. The RBA has in the past not always been as effective in communicating such nuance around risks to forecasts.

That said, it is clear that the hurdle for higher policy increments in Australia is considerable and was always much higher than a number of other “like” central banks (such as the Fed, the Bank of Canada and the Reserve Bank of New Zealand). This comes even as the RBA continues to talk tough on inflation.

On that score, the minutes appeared to indicate that the RBA had considered the approaches from the likes of the Fed, Bank of Canada and the Reserve Bank of New Zealand and is consciously eking out a different path. The minutes noted “that many major central banks had been raising policy rates quickly and were more likely to err on the side of doing too much rather than too little.”

In this context, the response from RBA deputy governor, Michele Bullock, to a question regarding the RBA’s comparative caution in only increasing the policy rate by 25 basis points at its last two meetings was illuminating. She stated that the RBA “could scorch the earth and get inflation back down very quickly” but questioned whether that was “the right thing to do” in terms of the potential costs to activity and employment.

Fair enough.

But drawing on the ‘70s experience, and in an echo of chairman Powell’s comments at his November press conference, an alternative construct is that that the “scorched earth” more likely comes from central banks exhibiting some prevarication in assuming a frontline and aggressive role in containing inflation and then having to slam the brakes aggressively later on in the piece.

Of course, the RBA might not be on a wrong tack. Time will tell.

But in contrast to inflation developments in the US, domestic price indicators continue to exhibit considerable momentum.

The September quarter wage price index (WPI) showed greater than expected acceleration in wages growth, both in terms of the market consensus forecasts and the forecast track from the RBA. The WPI measure that includes bonuses (which is more obviously pro-cyclical and more indicative of inflation currents than measures that exclude bonuses) increased by 4.1 per cent, its highest annual increase in almost 14 years.

There is the notion – that episodically comes up in RBA commentary – that Australia’s wage and inflation circumstances are “different” or somehow less challenging than elsewhere in the developed country complex. Certainly, any “difference” was not evident in either the September quarter CPI or WPI figures.

The NAB October monthly business survey indicated elevated price and cost pressures persisted into the December quarter.

Using price measures gleaned from the monthly survey, NAB economists construct a simple ‘nowcasting’ model of the trimmed-mean CPI. That model suggests trimmed-mean CPI of around 1.8 per cent (quarter-on-quarter) in the December quarter. That would see trimmed-mean CPI running at 6.8 per cent (year-on-year) for the December quarter, compared with an RBA forecast of 6.5 per cent issued just last week.

In other words, the upside risks to the RBA inflation forecasts issued last week are clear, as are the implications for monetary policy.

That underscores the key risk with the RBA approach: that it admits the possibility of the emergence of the sort of inflation inertia that was last experienced on a global scale in the late ‘70s / early ‘80s.

As the RBA governor has noted the path to returning inflation to the 2-3 per cent target and keeping the economy on an even keel “is a narrow one.”

I suspect that unlike the Fed, the RBA should be possessed of some anxiety as it approaches 2023.

UK inflation posts a 41-year high

In what has become a familiar circumstance the UK recorded a 41-year high inflation print in October. October headline CPI came in at 11.1 per cent up from the 10.1 per cent recorded in September. The core measure came in at 6.5 per cent unchanged from the 6.5 per cent recorded in September.

As has been discussed in the past, while the Bank of England is not solely responsible for the challenging economic circumstances currently facing the UK, by creating the impression that it was reluctant to embrace a frontline role to play in containing inflation, it is complicit in the creation of those challenging circumstances.

In this context comments overnight from Bank of England (BoE) governor Bailey on the turmoil wrought by the Truss Governments economic plans – while not inaccurate – were a little disingenuous. The Truss tax cuts were icing on the cake of BoE prevarication and the Johnson Government’s distractions that led to Brexit mismanagement, all of which are responsible for the potential stagflationary challenges facing the UK.

As mentioned elsewhere, the lessons from the ‘70s is that any delay on the part of a central bank in articulating a coherent and firm response to an inflation threat only heightens the risks down of a more damaging macroeconomic dislocation in terms of employment and activity down the track. In the post pandemic period the BoE, along with the European Central Bank (ECB), has been most lax in this regard.

The scale of rate hikes the BoE must now visit on the UK economy means that the feared “more substantial macroeconomic dislocation” canvassed above is already ‘baked in the cake’. Any further prevarication would only exacerbate an already difficult circumstance.

Canada inflation as expected. Signs of some benefit from earlier firm approach

Canada’s October inflation rate was largely as expected and less troubling than the UK release.

The October headline number was unchanged at 6.9 per cent while the core measures came in at 5.8 per cent down from 6.0 per cent. The key median and trimmed mean measures were at 4.8 per cent and 5.3 per cent respectively.

Canada’s inflation rate shows some tentative signs of at least stabilising prior to a turning point, possibly reflecting the Bank’s relatively aggressive approach to inflation in 2022. That was exemplified by a decision earlier in the year to abandon unambiguously the “transitory” inflation narrative and articulate a clear and credible strategy of dealing with the inflation challenge.

Like the Fed, the Bank of Canada were persuaded of the efficacy of getting to “neutral” quickly and engaged in sequential policy rate hikes of 50 basis points, 100 basis points, 75 basis points and 50 basis points in June, July, September and October respectively.

The October inflation result most likely will see the Bank of Canada maintain the policy rate increment at 50 basis points when it meets on 7 December.

Coming up: Australian October labour force

The Australian October labour force data to be released today are expected to show continued tight labour market conditions even if there might be a marginal retreat from elevated levels of labour market tightness in prior months. It is doubtful that retreat will be of sufficient magnitude to allay concerns about wage and price inflation contained in recent releases, including yesterday’s WPI and the September quarter CPI as well as those in the NAB monthly business survey. The September release revealed the unemployment rate close to a 50 year low at 3.5 per cent, with employment virtually unchanged. The consensus expectations reported by Bloomberg are for an increase in employment of circa 15,000 and a slight uptick in the unemployment rate to 3.6 per cent.

Regardless, it is difficult to argue against the proposition that labour markets are tight.

Anecdotes of this abound and the September NAB monthly business survey showed a buoyant labour market which reported and “ongoing difficulty finding suitable labour.”

Given recent price and wage data, it is difficult to see today’s labour force data being sufficiently strong to engender an increase in the policy rate increment when the RBA meets in December, even if that wage and price data may argue for a higher increment. It is more difficult to see it being weak enough to engender any “pause” from the RBA.

By Stephen Miller, investment strategist