Stephen Miller

Wednesday night’s release of the Federal Reserve’s (Fed) FOMC meeting minutes indicate that the Fed and financial markets are close to alignment on their expectations for peak policy rate of around 5 per cent in this cycle. There is some divergence around how quickly the policy rate might decline from there. But it is clear that after an aggressive Fed communication and action plan markets in the last month or two have got the message that the Fed’s primary goal is inflation containment and that it will take a policy rate of 5 per cent to achieve the requisite containment.

Last night’s minutes were consistent with the notion of a step-down in the policy rate increment to 50 basis points in December with “a substantial majority of participants judged that a slowing in the pace of increase would likely soon be appropriate,” given “the uncertain lags and magnitudes associated with the effects of monetary policy actions on economic activity and inflation.”

The minutes also suggest that a higher cyclical peak than previously expected is also likely with “various” officials concluding that “the ultimate level of the federal funds rate that would be necessary to achieve the committee’s goals was somewhat higher than they had previously expected.” This is consistent with Chair Powell’s comments at his press conference following the conclusion of the FOMC meeting on 2 November that “incoming data since our last meeting suggests that ultimate level of interest rates will be higher than previously expected”. The median September meeting “dot plot” suggested a terminal policy rate around 4.60 per cent. A new “dot plot” will be issued at the conclusion of the next Fed FOMC meeting on 14 December. A median “dot plot” peak close to 5 per cent looks likely which would essentially mirror current market pricing.

That meeting comes after the release of the November consumer price index (CPI) on 13 December. The lower-than-expected October CPI and producer price index (PPI) releases have increased confidence in financial markets of not only a step-down in the policy rate increment but that the end of the Fed’s tightening cycle is within sight.

In other words, the Fed will take smaller steps to a (modestly) higher peak.

The current judgement from financial markets would appear to vindicate the Fed’s approach.

Bond yields have fallen sharply, and equity markets have rallied.

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 have been mostly circumspect in their assessment of the degree to which the October figures would allow them to ease the foot off the brakes. That probably reflects a desire to consolidate the hard-won gains regarding market acceptance of its focus on inflation containment.

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 unnecessarily 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, [then] we can support economic activity strongly if that happens, if that’s necessary. On the other hand, if you make the mistake in the other direction, and …it’s a year or two down the road and you’re realising inflation behaving the way it can…you have to go back in. By 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 unexpected residence in household spending and employment, the Atlanta Fed ‘GDPNow’ estimate for Q4 is currently running at 4.3 per cent.

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

RBNZ ups the policy increment to 75bps; RBA to persist with an “Australian exceptionalism” narrative

While mostly anticipated, the Reserve Bank of New Zealand (RBNZ) yesterday raised the policy, official cash rate (OCR) by 75 basis points to 4.25 per cent. Furthermore, the Bank’s Monetary Policy Committee (MPC) projects an OCR of around 5.5 per cent by the September quarter 2023 up from previously forecast peak of 4.1 per cent in August.

In announcing the move, the RBNZ noted that the “the Committee agreed that the OCR needs to reach a higher level, and sooner than previously indicated, to ensure inflation returns to within its target range over the medium-term…core consumer price inflation is too high, employment is beyond its maximum sustainable level, and near-term inflation expectations have risen.”

Interestingly the RBNZ appeared to contemplate whether an even greater increase in the OCR was warranted by noting that “the Committee gave consideration to an increase in the OCR of 75 or 100 basis points.” It ultimately decided not to go down that path, adding that “on the balance of risks, the Committee agreed that a 75 basis point increase was appropriate at this meeting.”

New Zealand’s current inflation rate is on a headline basis at 7.2 per cent while on a trimmed-mean basis it is at 6.4 per cent (compared with 7.3 per cent and 6.1 per cent in Australia).

This suggests that the RBNZ is alert to the lessons from ‘70s style inflation: viz, that any prevarication in articulation of 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.

Some might argue that the RBNZ tips too much toward recession risks. However, that charge has also been levelled against the Fed who have exhibited a greater degree of aggression than the RBNZ through 2022 and yet, as noted above, there are grounds for some guarded optimism that that policy of aggressive inflation containment is on course to achieve its objectives without an excessive dislocation in terms of activity and employment.

Which brings me to the Reserve Bank of Australia (RBA).

It is clear that the hurdle for higher policy increments in Australia is considerable and much higher than a number of other “like” central banks (such as the Fed, the Bank of Canada and the RBNZ).

On that score, it appears that the RBA is consciously eking out a different path. The minutes from the November RBA meeting 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.”

Some of this reflects a belief in “Australian exceptionalism”: the notion that Australia’s wage and inflation circumstances are “different” or somehow less challenging than elsewhere in the developed country complex. The evidence for such “exceptionalism” is scant. Certainly, any “difference” was not evident in either the September quarter CPI or wage price index (WPI) figures.

Worryingly, it was a predilection toward “Australian exceptionalism” which was responsible for the egregious policy missteps from the RBA through 2021 and into 2022.

The RBA has defended its comparative caution by warning against “scorching the earth” to get inflation down implying a more aggressive approach involves outsized costs in terms of activity and employment.

But drawing on the ‘70s experience, and in an echo of chairman Powell’s comments at his November press conference (see above), 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 in the piece.

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

But 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.

While RBA communication may be more nuanced and, on the surface, at least gives the RBA optionality when it comes to policy, I fear that it is overly reluctant to aggressively “walk the walk” on inflation.

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 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 earlier this month.

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 a greater anxiety as it approaches 2023.

By Stephen Miller, investment strategist 

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