Stephen Miller

The Fed. Is the (recession) wolf finally at the door?

• For the last couple of years bond markets looked to have been ‘crying wolf” on recession prospects. Is SVB a harbinger of the recession wolf?
• Bond market was pricing SVB as akin to a ‘Lehman moment’.
• US February CPI showing only grudging progress on inflation. Underscores Fed predicament.
• Likely to be some adjustment to any pre-existing Fed plan for the policy rate but not to the extent reflected in market pricing.
• Fed likely to raise the policy rate 25 basis points at next week’s meeting. Absent SVB, 50 basis points was likely.
• Perhaps SVB is a mangy stray dog not a ferocious wolf.

NAB Monthly Business Survey data resistant to an April pause, Lowe’s path to becomes narrower?

• RBA Governor Philip Lowe has sensibly signalled a more flexible approach to future policy rate increases. Stresses data dependence.
• NAB Monthly Business Survey price, labour cost, activity and employment data fail to support the pause case. Inflation indicators from that survey indicate “sticky” inflation (a plateau rather than a peak?).
• Follows largely unremarked poor productivity data that saw growth in key unit labour cost gauge at above 7 per cent.
• Key labour force data not expected to support pause case.
• Australia has under-performed peers (US, Canada and even NZ) on inflation.
• Bank of Canada shows economic and political virtues of early aggressive action.
• Lowe’s ‘path’ has got narrower through 2022 because of a seeming reluctance on the part of the RBA to act aggressively in confronting inflation.
• Were the RBA to avail itself of the opportunity to pause without shifts in key data in place, the Governor’s path could be even narrower.

 The Fed: Is the (recession) wolf finally at the door?

Despite a stubborn failure for the data to conform, the bond markets have had a tendency over the past couple of years to ‘cry wolf’ regarding recession. Of course, that famous parable concludes with the wolf finally showing up. Markets certainly seem to think that the Silicon Valley Bank (SVB) collapse is a harbinger of the recession wolf.

Even before the SVB travails the Fed (and other central banks) were engaged in a high wire act: charting a path between getting inflation back toward target without tipping the economy into (deep) recession. Markets now seem to believe that the next part of that high wire act is to be completed with a blindfold and no safety net.

While not wishing to dismiss the SVB collapse as trivial, I harbour a suspicion that, as it has done consistently over the recent past, a skittish bond market has overestimated the extent of the likely decline in activity and employment that follows and, accordingly, has overestimated the rapidity with which inflation will fall.

There are two ways to view the SVB collapse:

• The first is that the SVB collapse is a somewhat isolated incident that reflected the idiosyncratic nature of SVB’s depositor base. And while that may engender a burst of heightened anxiety in financial markets, the response from the regulators, and in particular the guaranteeing of deposits, ultimately means that the Fed should retain a primary focus on inflation.
• The second is that the SVB is akin to a ‘Lehman moment’ and that the collapse of SVB is indicative of more systemic concerns and not only should the Fed desist from further increases in the policy rate, but it should be contemplating a reversal of those increases.

The bond market has clearly voted that the latter of these two representations as the appropriate one.

However, with at best only grudging progress in the fight against inflation, as evidenced by last night’s US February consumer price index (CPI) report, the Fed faces an apparent predicament. Should it persist with the already telegraphed monetary tightening? The answer from the CPI inflation report is a resounding yes.

The annual core CPI inflation rate was unchanged at a still elevated 5.5 per cent.

More importantly any progress in vanquishing inflation is barely perceptible in measures of the ‘inflation pulse’

The 3-month annualised core CPI was 5.2 per cent in February, up from 4.6 per cent in January and what was a 15 month low of 4.3 per cent in December. Similarly, the Cleveland Fed trimmed-mean measure rose to 6.3 per cent in February, up from 5.8 per cent in January and what was a 16 month low of 5.2 per cent in December.

The big question regarding future inflation has been over the trajectory of services inflation. Progress on that front seems to be less than the Fed would have hoped to achieve. The 3-month annualised services inflation rose to 7.5 per cent in February from 7.2 per cent in January. The 12-month change in the closely watched services ex-shelter component fell marginally in February, but remains elevated at 6.9 per cent.

It was the “stickiness” in services inflation that had kept Federal Reserve officials, including Chair Powell, on a hawkish tilt and had led markets to contemplate a peak policy rate approaching 6 per cent. That “stickiness” is still starkly evident.

Further, markets had also finally accepted Powell’s indications that not only was the policy rate going higher it was going to stay there for a considerable period: at least until the Fed could establish confidence that inflation was returning to target. That looked to be at least until sometime in 2024.

I had thought that 6 per cent was somewhat of a leap, but at the same time had thought that with US bond yields approaching 4 per cent, and with the Fed and the bond market more or less aligned in their views on the policy rate, US bonds looked reasonable in terms of offering a modestly attractive enough yield without the prospect of significant capital losses. In some (admittedly vague) sense I was “right for the wrong reason”.

Now, in the wake of the SVB collapse, markets are now pricing a peak rate close to 5 per cent around May but then some 70 basis points of policy rate reductions into the end of the year. That looks to be a bridge too far in terms of any adjustment to the Fed’s pre-existing plan.

To return to an earlier analogy, not only are markets expecting the tightrope walker to fall off, but in so doing, bringing down the whole circus tent and smothering every onlooker.

In other words, with bond markets seeing the SVB something of a ‘Lehman moment’. Current market pricing, even with some relative calm returning, seems to reflect an expectation of too great a decline in activity and employment and too rapid a decline in inflation.

In saying that, I’m not suggesting that it is prudent for markets (or, indeed the Fed) to regard the collapse with indifference. But the collapse did in the main reflect the idiosyncratic nature of SVB’s depositor base. Certainly, and appropriately, it has focussed attention on mainly regional banks that have an idiosyncratic depositor base (or other idiosyncratic features that attach to their business models), that leave them open to particular risk events. But it is a long way from a ‘Lehman moment’.

But importantly, the large systemically important banks with diversified depositor bases do not face the same problem. Indeed, Bloomberg reports that the likes of JP Morgan, Bank of America, Citigroup and Wells Fargo have received a torrent of deposits in the last few days. That makes the ‘Lehman’ systemic comparisons look overblown even if it doesn’t diminish the travails of the regionals.

Given the forgoing, and the given the grudging progress on inflation to date evident in the February CPI release, I think that the Fed should and will proceed with a further policy rate increase at the March meeting, and lean, without any great deal of conviction to a 25 basis point increase, followed by at least a total of 50 basis point more tightening through to year-end to take the policy rate to an upper limit of 5.5 per cent. I think in the absence of any SVB strains the increment would have been 50 basis points in March.

The SVB collapse is not a wolf, more a stray dog and a mangy one at that.

NAB Monthly Business Survey resistant to an April pause, Lowe’s path to become narrower?

RBA Governor Philip Lowe has sensibly signalled a more flexible approach to future policy rate increases

That gives the RBA the requisite flexibility to go to a “4 handle” if that is deemed necessary to contain inflation but should the labour market weaken substantially more than expected, or the price and wage data show a more substantial deceleration than expected, more modest rises or a “pause” might be contemplated.

In other words, future decisions on policy rate increases are data dependent.

The price data in the February NAB Monthly Business Survey argues strongly against any pause in hiking the policy rate. As do the activity and employment readings obtained from that survey.

While the Australian financial system is at the outer edge of the ripples from the SVB collapse, to the extent that the SVB collapse tempers the Fed’s disposition to raise the policy rate then that would also likely extend to the RBA.

That is regardless of the way the data falls because of the likely currency implications of a more moderate Fed.

But my view is that the market has overstated the influence of the SVB on the Fed’s path for policy rate increases. While the SVB collapse may temper at the margin the Fed’s disposition to increase the policy rate, I do not believe that any adjustment to any pre-existing Fed plan will be of the order of magnitude reflected in bond market pricing.

Back to the local data, one of the largely unremarked features of the December quarter national accounts was a steep fall in productivity: GDP per hour worked fell 3.5 per cent over the year to the December quarter 2022, meaning that unit labour costs (the most relevant labour cost gauge for inflation) increased by more than 7 per cent over the same period.

Measures of the Australian ‘inflation pulse’ from the NAB Survey indicate that inflation pressures remain extremely elevated into the March quarter 2023. The 3-month annualised measures of labour costs and retail prices are at 10.2 per cent and 9.5 per cent respectively and while they are down from their peaks, they remain at historically high levels compared with the trimmed-mean CPI. That may indicate that the latter, rather than reaching a peak, might simply be at a plateau, or that the path back toward the RBA inflation target might be a little more elongated than currently anticipated.

The next key data release is on Thursday with the February labour force data. An outcome close to market expectations of an increase in employment of circa 50,000 and a decline in the unemployment rate to 3.6 per cent would also argue against an April pause.

Australia has underperformed its peers, such as the US, Canada and even New Zealand, on inflation. That is at least in part because of a less aggressive approach to policy rate increases. That can be perceived as exhibiting some prevarication in confronting the inflation challenge.

Even given the grudging progress on inflation in the US, it is some way down from the peak around the middle of last year.

Canada’s peak is even more apparent

The Bank of Canada (BoC) could credibly opt to “pause” further increments in the policy rate at last week’s BoC meeting. The BoC has delivered a total of 425 basis points worth of tightening in this cycle making it among the more aggressive of developed country central banks. The pause came after the release of January inflation numbers that showed signs of a meaningful turning point in inflation, reflecting the Bank’s relatively early display of monetary policy aggression.

There is no such turning point yet evident in the Australian quarterly CPI data.

As far as the Government goes, I would have thought that the best “political” strategy given the election cycle is to get interest rate rises out of the way more quickly rather than draw them out (“death of a thousand increases”). A premature pause may require the RBA to slam the brakes later in the cycle resulting in an even greater dislocation in activity and employment. That is the lesson to be drawn from the experience of the late ‘70s and early ‘80s.

The Bank of Canada showed the (economic and political) virtues of the alternative approach of aggressively confronting the inflation challenge.

In the past the Governor has mentioned that the path between the vanquishing of inflation and avoiding a recession, or at least a sharp growth slowdown, is a narrow one.

My view is that path has got narrower through 2022 because of a seeming reluctance on the part of the RBA to act aggressively in confronting inflation.

The summer saw a renewed aggression on the part of the RBA but that which has been walked back somewhat in the last month. While that is defensible as far as it has gone, given the NAB survey and the anticipated labour force data, and in the absence of a deterioration in the health of the international financial system on a scale that begins to resemble the Lehman episode, it will take an unexpected downshift in the monthly CPI indicator at the end of this month to justify an April pause.

Were the RBA to avail itself of the opportunity to pause without the forgoing conditions in place, the Governor’s path could get even narrower.

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