Stephen Miller
Markets juggle the ‘hot potato’ of policy guidance as central banks search for ‘wiggle room’
One of the earlier hits of renowned Australian kids band, the Wiggles, involved juggling a ‘hot potato’. Currently, that seems an appropriate metaphor for the world of central banking as central banks seek to finesse their guidance – create some ‘wiggle room’ – leaving markets juggling the ‘hot potato’ of policy rate expectations.
- The Reserve Bank of Australia (RBA) gives itself ‘wiggle room’ on the less hawkish side. Australian interest rate markets vulnerable to further negative (upside) surprise?
- The US Federal Reserve (Fed) gives itself ‘wiggle room’ on the more hawkish side. US interest rate markets vulnerable to further positive (downside) surprise?
- The Bank of Canada doesn’t need much ‘wiggle room’ at all.
- Coming up: US February non-farm payrolls on Friday ahead of US February CPI on Tuesday.
- Outgoing Bank of Japan Governor, Kuroda, to leave his successor ‘maximum wiggle’? There is some (minority) speculation that Kuroda may adjust or scrap altogether the central bank’s yield curve control program. That is highly unlikely in my view.
RBA gives itself more ‘wiggle room’
RBA Governor Philip Lowe’s comments yesterday and his Statement on Tuesday following the RBA’s 25 basis point (bp) increase in the policy rate to 3.60 per cent signals a more flexible approach to future policy rate increases. That said, the RBA believes that it will have to tighten monetary conditions further, but it is prepared to observe how key price and labour market data unfold before deciding on the extent of future increases in the policy rate.
My view remains that the policy rate will need a ‘4 handle’ to adequately tackle inflation. Nevertheless, the Governor’s approach is sensible and gives him the requisite flexibility to go to a ‘4 handle’ if that is deemed necessary, but also should the labour market weaken substantially more than currently expected, or the price and wage data show a more substantial deceleration than currently expected, more modest rises or a ‘pause’ might be contemplated. That flexibility – or ‘wiggle room’ – reflects some modestly softer labour market data as well as modestly softer official wage data and indications from the monthly consumer price index (CPI) that inflation pressures may have peaked.
However, in my view it is not clear that inflation has peaked in the sense that a meaningful turning point is imminent. One of the largely unremarked features of last week’s national accounts was a steep fall in productivity: Gross domestic product (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. That could mean that any peak in inflation may simply presage a plateau rather than any meaningful turning point.
The US and European experiences add a cautionary note. After inflation appeared to turn down toward the end of 2022 in both the US and Europe, progress since that time has been somewhat more tempered than had been anticipated.
My view that a ‘4 handle’ is required is a little above what is currently reflected in market pricing leading to a belief on my part that interest rate markets in Australia are setting themselves up for a negative (upside) surprise.
For the April meeting key domestic data are as follows:
March NAB Monthly Business Survey on 14 March. The key focus will be on the price and labour cost measures. While these have been trending down, they remain well in excess of what is showing up in official measures and by margins that look historically high. That raises some question over whether the official measures would also turn down or whether they might exhibit a degree of ‘stickiness’. That is, some of the ‘catch up’ required to return the NAB and official measures to their historical relationship is reflected in the official measures staying high even as the NAB measures trend down.
February Labour force data on 16 March. Following softer reads in December and January, for a March policy rate increase to remain on the agenda there would need to be some growth in employment and a stabilisation of the unemployment rate at 3.7 per cent.
February Retail trade data on 28 March. A modest growth rate after a very weak December and a partial bounce-back in January would buttress the case for a further increase.
Monthly CPI indicator on 29 March. Annual rates of inflation above 7 per cent would mean further rate rises remain on the agenda. An appreciable step-down in the annual rate of inflation to something with a ‘6 handle’ from the current 7.4 per cent would add to pressure for a ‘pause’ in the policy rate.
Of course, the major data point is the March quarter CPI to be released on 26 April. That will need a meaningful turning point in annual trimmed mean inflation to something approaching 6.5 per cent or lower to justify no change in the policy rate from here.
Fed also seeks ‘wiggle room’
In Congressional testimony this week, US Federal Reserve Chair Powell also sought to convey to legislators that he needed flexibility. However, in contrast to the circumstance in Australia that was because price and labour market data have surprised on the upside (albeit that US measures of inflation are below those in Australia).
After having raised the policy rate by ‘only’ 25 basis points (bps) at its January meeting after meaningful turning points in inflation toward the end of 2022, it would appear that inflation and labour market resilience exhibited so far in 2023 may have provided some food for thought as to whether the signal sent by such a move – that the cyclical peak in the policy rate was near – might have been premature.
The question of whether the Fed decides on a 25bp or 50bp increment at the FOMC meeting that concludes on 21 March remains an open question. Indeed that was evident in Chair Powell’s overnight testimony where he noted that in relation to the size of the policy increment to follow the upcoming Fed FOMC meeting on 20 – 21 March that “…I stress that no decision has been made on this…”.
As in Australia there are critical data points to be negotiated prior to that meeting commencing with the all-important February non-farm payrolls report on Friday evening and the February consumer price index (CPI) next Tuesday.
If the unemployment rate were to persist at 3.4 per cent, and employment to increase by say more than 250,000, and the annual core CPI rate to persist at 5.6 per cent or rise further, then a reversion to 50bp increments becomes more likely for the March meeting. Although obviously the detail (particularly service sector price pressures in the CPI) will be important. I am sanguine enough to imagine that confluence of events is unlikely but confess to a lack of conviction on that score. The January Job Openings and Labor Turnover (JOLTs) report overnight indicated persistent high levels of vacancies while the ADP report also indicated a higher level of employment than anticipated. The latter, however, is not always a great guide to the payrolls report and it certainly didn’t foreshadow January’s blockbuster employment report.
Probably reflecting some ‘stickiness’ in services inflation, Federal Reserve officials, including Powell in his Congressional testimonies this week, continue to adopt a hawkish stance.
At this stage I’d continue to conjecture a total of 75bp increase from the Fed in 2023 taking the upper limit of the policy rate target to 5.5 per cent, with clearly some upside risk.
However – and clearly contingent on the data – I suspect US interest rate markets appear to have adequately reflected the Fed’s hawkishness and I suspect that expectations of the peak policy rate are not that different between markets and the Fed. I suspect also that markets have in the main reflected the ‘higher for longer’ mantra from the Fed. On that basis I think the capacity for upside surprise for US interest markets is less than it is for Australia.
That to me continues to suggest that the US 10-year bond yield is probably range-bound around a mid-point close to 4 per cent. On that basis it is not a stretch to posit that government bonds offer investors a modestly attractive enough yield without the prospect of significant capital losses.
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 stabilizing 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.
Bank of Canada doesn’t need much ‘wiggle room’
As was largely anticipated, having already been transparently telegraphed, the Bank of Canada opted to ‘pause’ further increments in the policy rate.
The Bank of Canada has delivered a total of 425bps worth of tightening in this cycle making it among the more aggressive of developed country central banks. The move came after the release of January inflation numbers that showed signs of a meaningful turning point in inflation, possibly reflecting the Bank’s relatively early display of monetary policy aggression.
That earlier aggression has seen the Bank of Canada arrive at a position to credibly contemplate a ‘pause’.
The Bank did flag, however, that they’re still weighing whether additional hikes will be needed to rein in inflation.
Coming up: US February non-farm payrolls report
US February payrolls report
The January non-farm payrolls report was a blowout relative to expectations. Employment was up sharply (571,000) while the unemployment rate fell to a more than 52-year low of 3.4 per cent, having last visited that level in May 1969. There was some conjecture that weather-related events may have overstated labour market strength and the February number will be closely watched in order to establish the veracity of that conjecture.
The January Job Openings and Labor Turnover Survey (JOLTS) report released earlier in the week revealed some decline in job vacancies from December’s surprisingly strong number, but they remain at elevated levels. On that basis there are 1.9 job openings per unemployed person in the US which is indicative of ongoing labour market tightness. Chair Powell in the past has remarked that he would like to see that figure closer to 1.
The February Institute for Supply Management (ISM) Purchasing Manager Index (PMI) for Manufacturing showed weaker employment conditions. However, the same Services PMI showed a large rise in the employment component up to 54.0 from 50.0 in January.
The ADP measure showed a higher than anticipated 242k increase in employment in February, although, as remarked above, the prior measures were never a great guide to the Bureau of Labor Statistics report and it certainly didn’t foreshadow January’s blockbuster employment report.
According to Bloomberg, market expectations for US September non-farm payrolls are in for an increase in employment of around 203,000 (from 571,000 in August) and an unemployment rate at 3.4 per cent which, as mentioned above, is a level that prior to January hadn’t been seen since May 1969. Coming on top of a strong January report, outcomes in line with that expectation may tip the balance on the FOMC to again contemplate a reversion to a 50bp policy rate increment. However, Tuesday’s CPI release probably looms as the more important data point prior to the FOMC meeting on 20 – 21 March.
Bank of Japan
There is some (minority) speculation that Kuroda may leave his successor gargantuan ‘wiggle room’ by adjusting or scrapping altogether the central bank’s yield curve control program. That is highly unlikely in my view.