The Fed remains primarily focussed on inflation containment – 2023 will be a year of slow growth
Stephen Miller
US Federal Reserve (the Fed) FOMC minutes
Last night’s release of the US Federal Reserve’s (the Fed’s) Federal Open Market Committee (FOMC) meeting minutes indicate that the Fed remains primarily focussed on inflation containment and that a further increases in the policy rate beyond those implied by the December “dot plot” are likely.
The minutes stated that “participants generally noted that upside risks to the inflation outlook remained a key factor shaping the policy outlook, and that maintaining a restrictive policy stance until inflation is clearly on a path toward 2% is appropriate from a risk-management perspective”.
Nevertheless the Fed and financial markets are now close to alignment on their expectations for peak policy rate of somewhere close to an upper limit in the policy rate of around 5.5%.
Since the Fed signalled a more aggressive campaign at the start of 2022 and certainly after upping the ante from mid-2022 with a series of four consecutive 75 basis point policy rate hikes, markets have appeared reluctant to accept the Fed’s more determinedly hawkish stance. But in the wake of a higher than anticipated January CPI result and an aggressive Fed communication and action plan, markets more recently have accepted the message that the Fed’s primary goal is inflation containment and that it will take a policy rate of near 5.5% to achieve the requisite containment. Moreover, prior expectations regarding an easier stance of monetary policy in the second half of 2023 have been substantially unwound as markets digest the Fed’s “higher for longer” message.
Having said that, measures of the ‘inflation pulse’ are down from their peak even if newly updated seasonal factors have seen the extent of that decline to be less significant than it had appeared. The 3-month annualised core CPI was 4.6% in January, up from 4.3% in December but well down from a peak of 7.1% in June. Similarly, the Cleveland Fed trimmed-mean measure was at a still elevated 5.8% in January, up from 5.2% in December but well down from a peak of 7.8% in June.
The big question regarding future inflation is over the trajectory of services inflation. On that front the jury may still be out as 3-month annualised services inflation rose to 7.2% in January from 6.4% in December but down from a peak above 11% in May. The closely watched services ex-shelter rose back above 4% in January after plunging to under 1% in December.
Probably reflecting some “stickiness” in services inflation, Fed officials continue to adopt a hawkish stance and at this stage I’d conjecture probably three more 25bp increases from the Fed in 2023 taking the upper limit of the policy rate target to 5.5%.
The forgoing notwithstanding, a US 10-year bond yield is probably range-bound around a mid-point close to 4%. On that basis it is not a stretch to posit that bonds (government and corporate) offer investors a modestly attractive enough yield without the prospect of significant capital losses. In other words, it may be time to “dip a toe in the water” on bond exposure.
A proximate stabilisation in bond yields may be good news for US equity markets, representing as it does the abatement of what has been a significant valuation headwind. However, while equities benefit from stabilising bond yields, the question remains whether earnings estimates have appropriately priced the cyclical downside. Depending on the extent of cyclical downside, equities seem likely to offer single digit returns and perhaps more if any recession is shallow and short-lived.
Markets are a little schizophrenic flitting between a ‘Goldilocks- extra lite’ scenario of stabilising bond yields and grudging advances in equity markets to one where Fed “over-tightening” plunges the economy into recession.
Of course, recession remains the big question. In terms of commentary, recession talk was around for much of 2022, particularly in the second half of that year when the Fed embarked on four successive 75bp policy rate increments. Thus far, the data has not validated that recession view, particularly given the labour market’s extraordinary resilience and even the latest Atlanta Fed GDP ‘nowcast” has first quarter GDP growing at a respectable 2.5% after 2.9% in Q4 2022 and 3.2% in Q3 2022.
I remain slightly more inclined toward the ‘Goldilocks – extra lite’ but accept the ride may be a volatile “two steps forward; one step back” scenario.
That narrative seems plausible but is a highly US centric one. The challenges loom larger in the Eurozone, in the UK (even after a better January inflation report) and in Australia.
Modest wage price index (WPI) growth points to only a 25bp increase from the RBA in February
The December quarter wage price index (WPI) registered a rate of growth somewhat less than had been anticipated by markets and at the margin may indicate some easing of labour market tightness.
The annual rate of growth was in private sector wages (excluding bonuses) was 3.6%. Taken at face value that is not a number that should escalate the pressure on the RBA, even if it is the highest annual rate of increase in that series in over a decade.
However, the quantum of the increase in the WPI series has long been at variance with a number of other indicators which show appreciably higher rates of increase, including those contained in the NAB Monthly Business Survey and the national accounts based measures as well as some anecdotal reports. The national accounts measure will be updated next week with the issue of the December Quarter 2022 national accounts. There is some conjecture that the WPI is not entirely effective in capturing de facto wage increases that occur via “classification creep”.
In that context, the WPI numbers by themselves are not sufficient to engender any “pause” in increasing the policy rate when the RBA Board meets to consider a variation in the policy rate on March 7th. It is almost certainly sufficient, however, to limit the size of that increase to 25 basis points.
The RBA minutes of the February meeting released on Tuesday indicated that that the RBA Board considered two options at that meeting; a 25 basis point increase or a 50 basis point increase, with the Board deciding there was a stronger argument for a 25 basis point move. This indicates a high bar to a reversion to 50 basis point increases.
Those February minutes were in contrast to the minutes of the December RBA Board meeting that indicated a “pause” in increasing the policy rate was also on the table as well as the 25 and 50 basis point options. To my mind that was too big a swing in the policy optionality pendulum from the specificity of “no increase in the policy rate before 2024” to one that is so wide that it becomes almost meaningless. Moreover, to openly contemplate a “pause” when all indications were that inflation momentum continued unabated was highly questionable.
The February minutes reiterated that message saying that “further increases in interest rates are likely to be needed over the months ahead. So I expect that as in February the Board will consider a 25 or 50 basis point hike and comfortably opt for the former.
The pandemic saw monetary policy assume unprecedented levels of accommodation. Viewed through that lens, policy adjustments through 2022 may have represented a partial return to some version of normality and perhaps significantly tighter conditions are yet required to meet the inflation challenge.
Drawing on the ‘70s experience the least costly path in containing inflation in terms of potential dislocations in activity and employment, is to be aggressive early in the piece. It was this recognition that drove the Fed and the Bank of Canada to aggressively hike their policy rates in 2022. It is no coincidence that those economies are closer to some respite from inflation than other developed market economies, including Australia. Canada’s January inflation numbers released on Tuesday revealed an unambiguous turning point in inflation pressures suggesting that the Bank of Canada may well “pause” the process of policy rate increments when it next meets on March 8th (the policy rate in Canada now stands at 4.75% compared with 3.35% in Australia).
A more acute dislocation of activity and employment comes from central banks exhibiting excessive caution in in containing inflation and then having to slam the monetary brakes later in the piece. The path between containing inflation and recession becomes narrower the longer central banks delay aggressive action against inflation. The RBA’s prevarication through 2022 has meant that path has got much narrower than necessary.
Of course, if next week’s national accounts based measures indicate a sharper deceleration in wage growth the policy calculus could get a little more interesting. A large downside surprise is not implausible but in my view is unlikely. Therefore, the policy rate will probably require a “4 handle” before the RBA can afford to follow the Bank of Canada’s lead. Such a scenario is now (finally) reflected in market pricing.
That means 2023 will be a year of slow growth – perhaps even recession. That slowing growth was “baked in the cake” some time ago when nearly every developed country central bank was late in recognising the persistence, magnitude, and momentum in inflation and that the attendant fallout from the pandemic was not as bad as initially feared.
Those central banks who prevaricated on assuming a more aggressive role in inflation containment, including the RBA, potentially face bigger challenges. That prevarication has raised the probability of a more extended period of slower growth culminating in a more substantial dislocation to employment and activity.
And even if the path between inflation containment and recession has grown even more narrow through 2022, now that the RBA and its Governor appear more focussed on inflation might mean that the path is navigable but continued inflation containment action remains the key.
As expected, the RBNZ downshifts to a 50 basis point policy increment
In a move that was largely anticipated the RBNZ yesterday raised the policy (OCR) rate by 50bps to 4.75% (even if the option of a 75 basis point increase was canvassed). The policy increment was a step-down from the 75bps implemented in November. However, the Bank’s Monetary Policy Committee (MPC) continues to projects an OCR of around 5.5% by the end of 2023.
Some, albeit tentative, sign of stabilising inflation combined with softer labour market outcomes and the near-term hits to growth in the wake of Cyclone Gabrielle are cited as the reasons behind the step-down in the policy rate increment.
However, Cyclone Gabrielle will likely result in some near-term inflation pressures given the hit to capacity and infrastructure.
The RBNZ said it’s too early to accurately assess the monetary policy implications of the storm given that the timing, size, and the nature of the government’s fiscal response were yet to be determined. However, it added that the current assessment is that over coming weeks, prices for some goods are likely to spike and activity will be weaker than previously expected.
In this context the RBNZ noted that monetary policy will be “set with a medium-term focus, and the Committee will look through these short-term output variations and direct price effects”.
The central bank reiterated it expects a recession starting in the second quarter of this year, but the economy is seen bouncing back a little sooner next year.
Inflation will accelerate to 7.3% in the March quarter 2023 will be slightly firmer than previously expected through the second half of 2023 but is forecast to return to the top of the central bank’s 1-3% target range by the September quarter of 2024. In the December quarter New Zealand’s inflation rate on a headline basis came in at 7.2% while on a trimmed-mean basis it averaged around 6.3% (compared with 7.8% and 6.9% in Australia).
The RBNZ’s downshift to 50 basis point increments brings it closer to global peers that have slowed the pace of tightening but it remains at the upper end of recent increases.
Indeed, despite being among the more aggressive of central banks when it comes to policy rate hikes, it has not made as much progress as similarly aggressive central banks such as the Fed and the Bank of Canada, possibly reflecting regulatory frustrations and / or idiosyncrasies associated with the pandemic and now weather-related developments.
By Stephen Miller, investment strategist
