Stephen Miller
The CPI and the Fed: more like one and done rather than none and done
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 and the recession wolf will show up at some stage.
However, the bond market has not recently proven a timely recession sage and has proven to be even less of a sage when it comes to predicting Federal Reserve (Fed) action.
Last night’s March US consumer price index (CPI) report does contain some slivers of good news, but the overarching conclusion is one of only grudging progress in the fight against inflation. This comes after Friday’s non-farm payrolls report indicating ongoing resilience in the labour market, albeit with some disinflation in wage growth.
The annual core CPI inflation rate ticked up to 5.6 per cent from 5.5 per cent in February.
More importantly measures of the ‘inflation pulse’ remain elevated even if there are some signs of good news.
The 3-month annualised core CPI was 5.1 per cent in March, down a little from 5.2 per cent in February but up some way from a recent trough of 4.3 per cent in December. The Cleveland Fed trimmed-mean measure fell to 5.2 per cent in March, from 6.3 per cent in February and is now at the same level as the recent December trough.
The big question regarding future inflation has been over the trajectory of services inflation. There is some evidence of slight moderation in selected measures of services inflation but progress is probably less than the Fed would have hoped to achieve. The 3-month annualised services inflation fell to 7.1 per cent in March from 7.5 per cent in February but remains above the recent trough of 6.4 per cent in December. The closely watched services ex-rent of shelter rose a substantial 0.6 per cent in seasonally adjusted terms in March, but the annual rate fell to 6.1 per cent in March from 6.9 per cent in February. While that annual rate remains elevated the March read is the lowest since May 2022.
It is the “stickiness” in services inflation that has led Federal Reserve officials, including Chair Powell, to leave open the prospect of a further Fed hike in the policy rate. The March report is consistent with ongoing “stickiness”.
Markets have moved to some acceptance of the prospect of a further hike.
However, there remains some difference in view when it comes to how soon the Fed may start reducing the policy rate.
The Fed has consistently maintained a “higher for longer” characterisation of the likely policy rate path. The bond market on the other hand is pricing some 60 basis points (bps) of policy rate reductions from a peak that is not that far from the current 5 per cent upper limit for the policy (federal funds) rate.
My assessment is closer to that of the Fed. The bond market has consistently over-estimated the rapidity with which the inflation rate would decline and has consistently under-estimated how high the Fed would take the policy rate. Moreover, the Fed’s FOMC median forecasts have gross domestic product (GDP) growing at only 0.5 per cent this year and the unemployment rate rising to 4.6 per cent. That is not inconsistent with a shallow recession (of which there are still only scant signs). That means it will take more than a shallow recession for the Fed to meaningfully change course. Such a scenario is not implausible, just unlikely in my view.
It would not surprise to observe persistent “stickiness” in inflation even if some of the cyclical inflation tailwinds are in some form of abeyance. The reversal of structural currents that account for the deflationary tendency of the past three decades is ongoing: viz; globalisation of labour supply (after the fall of the Berlin Wall and the “export” of labour from large emerging market economies such as China and India) is abating, globalisation of goods markets is in retreat as governments everywhere introduce protectionist measures under the guise of “industrial policy” and “national champions”, while domestic regulation of markets is increasing in scope (leading to upward price pressures) and baby boomer workforce participation is declining (limiting labour supply). The transition to clean energy involves ongoing costs to business, which is not to say it is undesirable, but it does complicate the task for inflation-focussed central banks.
The above makes me view current US bond yields as over-extended on the downside and it would not surprise me to see bond yields grind higher as we approach the northern summer.
And one and done looks a more likely exemplar for the Fed than none and done.
The RBA’s narrow path a tightrope?
The RBA Board decided at its April meeting to leave the policy rate unchanged at 3.60 per cent.
That “pause” confirms the RBA’s status as among the developed world’s more dovish central banks.
While the decision to “pause” it not indefensible, it indicates one of two things (or perhaps a combination of both) that underscore an inherent riskiness with the RBA’s approach.
First, that the RBA has an inflation view located very firmly at the more sanguine end of the risk continuum.
Second, the RBA believes it doesn’t have to be in any sort of hurry to return inflation to target. In his National Press Club speech following the April decision to “pause”, the Governor stated that the Board had discussed “whether it would be beneficial to get inflation back down to 3 per cent a year earlier … but it would mean job losses … and our judgment at the moment is that if we can get inflation back to 3 per cent by mid-2025, and preserve many of those job gains that have been delivered in the last few years”.
Fair enough!
However, I would make two observations.
RBA forecasts of inflation have been way too optimistic for some 2 years and that there is now a well-established pattern of the RBA’s inflation forecast needing to be re-cast upwards within a quarter of being released.
And with regard to the inflation / jobs trade-off, similar thinking lay behind central banks’ cautious approach to the fight against inflation in the late 1970s. What unfolded, however, was that inflation expectations became unanchored and an outsized dislocation in employment followed as central banks were forced to slam the monetary brakes harder later in the piece.
In his statement issued following the April RBA Board meeting, Governor Lowe asserted that inflation expectations remain “well anchored”.
How that squares with the Australian Council of Trade Unions (ACTU) decision to pursue a 7 per cent wage increase for workers subject to minimum and award wage arrangements at the Fair Work Commission’s (FWC) annual review is difficult to fathom. The ACTU claim – if entirely understandable – is a worrying portent of future inflation. An indication from the Government that it would support an increase in the minimum wage in line with inflation (or something close to it) is also a concern. While well-intentioned, such claims if granted may simply spur inflation pressures as they ripple through the award system, and beyond, at a time when productivity has been going backwards. It is also unlikely to achieve the stated aim of lifting living standards of low-paid workers, as any gains are eaten up by higher living costs through inflation and – ultimately – higher interest rates and / or higher unemployment.
Some of the RBA caution reflects a belief in “Australian exceptionalism”: the notion that Australia’s wage and inflation circumstances are somehow less challenging than elsewhere in the developed country complex. The evidence for such “exceptionalism” is scant.
Trimmed-mean measures of inflation are at the high-end for developed market economies and is likely to remain so after the release of the March quarter CPI on 26 April 26.
Indeed, changes to the regulatory environment, particularly in relation to the wage-setting framework, run the risk of entrenching higher inflation in Australia compared to elsewhere.
High frequency data such as the NAB monthly business survey continue to indicate considerable wage and price momentum. Even given the moderation in the NAB labour cost and price series evident in the March Survey, they remain elevated and well in excess of their historical levels vis-a-vis the trimmed-mean CPI. That suggests upside risk to the RBA’s trimmed-mean inflation forecast.
The key risk with the RBA approach is 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 1970s / early 1980s and the much higher costs in terms of dislocations to growth and employment that follow as the central bank attempts to wrestle the inflation genie back in the bottle.
Of course, it is not axiomatic that the RBA approach leads to a replay of the late 70s / early 80s episode, but there are parallels even if the orders of magnitude involved are not as confronting.
That may indicate that inflation, rather than reaching a peak, might simply be at a plateau, or that the path back toward the RBA inflation target might be even more elongated than currently anticipated.
As the Governor has mentioned, the path between the vanquishing of inflation and avoiding a recession, or at least a sharp growth slowdown, is a narrow one.
If the RBA persists with its “pause”, the Governor’s path could get “tightrope narrow” – and the safety net looks ragged!
