Stephen Miller
In something of a surprise move the Reserve Bank of New Zealand (RBNZ) increased the policy rate by “only” 25 basis points (bp) to 5.5 per cent. Moreover, the RBNZ Monetary Policy Committee (MPC) channelled their inner Jim Morrison by suggesting a “break on through to the other side” with the next policy shift expected to be an easing, albeit that looks to be at least a year away.
Financial markets were wrong-footed by the move thinking that after what looked to be an expansionary budget, the RBNZ would continue the hawkish tack that it displayed at the last meeting in April when it surprised markets with a hawkish 50 bp increase. However, at yesterday’s meeting the RBNZ MPC members even discussed the option of keeping rates unchanged but ended up voting in favour of one last increase by a 5-2 margin.
The New Zealand dollar (NZD) fell around 1 per cent in the wake of the decision while bond yields fell sharply – 2 year yields fell circa 30 bps in the wake of the announcement, while 10 year yields fell circa 15 bps.
The RBNZ Statement pointed to the notion that with the policy rate expected to stay at 5.5 per cent for around about a year, the MPC “is confident that…consumer price inflation will return to within its target range of 1-3 per cent per annum, while supporting maximum sustainable employment.” Forecasts issued with the announcement of the decision show that the RBNZ forecasts inflation to return to that range in the second half of 2024.
Given that it has been among the more hawkish of central banks, the fact that the RBNZ is among the first to signal the end of the tightening cycle should maybe not surprise too much.
It will also inevitably excite speculation about whether other central banks are near or already at the end of that process.
I would be wary of drawing too much by way of parallels for other central banks from the RBNZ signalling an end to the tightening cycle. Certainly, the Bank of Canada (BoC) and the Federal Reserve (Fed) may already be there given that inflation in those jurisdictions appear to have passed meaningful turning points. The Fed and BoC, along with the RBNZ, moved quickly through 2022 to try and get ahead of the inflation curve after a stuttering start in 2021.
However, when it comes to other developed country central banks, such as the Reserve Bank of Australia (RBA), the European Central Bank (ECB) and the Bank of England (BoE) the picture is less clear (particularly the latter given the worse than expected April UK inflation numbers released overnight). While latterly those central banks have adopted a less ambiguous approach to inflation containment, a sporadic proclivity to prevaricate on inflation containment through 2022 points to “stickier” inflation, and has arguably left them with more to do.
The RBA policy rate at 3.85 per cent is 165 bps below that in NZ.
Moreover, the period ahead does contain a number of elements that might upset any benign view about how inflation might return to target.
There is some conjecture that the Wage Price Index (WPI) is not entirely effective in capturing de facto wage increases that occur via “classification creep”. The national accounts measure of wages will be updated on the 7 June with the issue of the March Quarter 2022 national accounts.
That national accounts release will also provide an update on productivity, the lack of growth of which has been a source of anxiety for the RBA. The RBA Board May meeting minutes implied that poor productivity growth (the counterpart of which is higher unit labour cost growth) was in part behind the decision to increase the policy rate at that meeting given the need “to ensure consistency of the wages growth forecast with the Bank’s inflation forecast .”
The December quarter national accounts revealed 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.
Inconveniently, the March quarter national accounts are released a day after the next scheduled RBA Board meeting on the 6 June meaning the national accounts based wage and productivity data will not be seen by the RBA Board until the Board meeting scheduled for 4 July.
Also, looming is the Fair Work Commission (FWC) annual wage review, including consideration of the Australian Council of Trade Unions’ (ACTU) submission calling for a 7 per cent wage increase for workers subject to minimum and award wage arrangements. The Government has indicated support for the ACTU position with respect to the minimum wage increase but has been a little more circumspect regarding any extension to awards.
The ACTU claim – if understandable – is a worrying portent of future inflation. Such claims, if mostly granted, may simply spur inflation pressures as they ripple beyond the minimum / award wage complex, particularly if productivity growth languishes. The granting of claims is also unlikely to fully 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.
Changes in the regulatory environment, particularly in relation to the wage-setting and industrial relations framework, also run the risk of entrenching higher inflation in Australia compared to elsewhere.
These are domestic developments upon which the RBA will cast a keen eye.
There are also global structural currents that make elevated developed-country inflation rates more “sticky”. The 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”; domestic regulation of markets is increasing in scope (leading to upward price pressures); and baby boomer workforce participation is declining (limiting labour supply and lifting wages).
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-focused central banks.
To be fair, Australia’s high immigration rate somewhat mitigates these influences over the longer-term but won’t eradicate them. Indeed, in the short-term, pressure on housing rents from immigration may tip inflation risks the other way.
The forgoing leads me to conjecture that the policy rate will need to have a “4 handle” in order to bring inflation back to the 2 to 3 per cent target zone within an acceptable timeframe while minimising the dislocation in activity growth and employment.
If the RBA Board is of a similar mind, it might take the view that it is better to arrive at the terminal rate quickly and a rate increase might be on the cards at the June meeting. In that context, press reports that Governor Lowe expressed ongoing concern on inflation to MPs this week is potentially illuminating.
Bank of England struggling to break through to the other side as UK inflation exceeds expectations…again! A template to avoid?
The Bank of England (BoE) are some way from their inner Jim Morrison.
In what has become an all too familiar occurrence, the UK recorded a higher than expected consumer price index (CPI) inflation print for March.
Headline inflation declined to 8.7 per cent on energy base-effects but was higher than the 8.3 per cent expected.
Core inflation came in at 6.8 per cent versus 6.2 per cent expected.
The CPI report comes after BoE Governor Bailey told a UK Parliamentary Committee that if there was “evidence of more persistent [price] pressures, then further tightening in monetary policy would be required.” There is now a clearly visible “smoking gun” of evidence.
The April CPI numbers almost certainly mean a further increase of at least 25 bps in the policy rate at the next scheduled BoE meeting on 22 June taking the policy rate to at least 4.75 per cent. Indeed, given the magnitude of the data surprise, and coming after the March figures also surprised on the upside by a considerable margin, it may be that discussions of a 50 bp increase make the June agenda. Peak policy rate pricing is now close to 5.25 per cent.
Of course, the Bank of England is not solely responsible for the awkward circumstance in which the UK economy finds itself. The mismanagement of Brexit occasioned by a distracted Johnson Government and the turmoil wrought by the Truss Government indisputably played major roles.
But at various times through 2022 it created an impression that it was reluctant to embrace a frontline role in containing inflation. In that sense it is complicit in the creation of the challenging circumstances created by the stubborn UK inflation, even if more recently it has hardened up its anti-inflation rhetoric somewhat.
The UK inflation report stands in contrast to the (admittedly grudging) progress in the US and Canada and even NZ (see above) where after a stumbling start those central banks retained an aggressive and unambiguous focus on inflation. There is evidence that approach is close to achieving its aims and that the tightening process is drawing to a close in those three jurisdictions.
The lesson from the ‘70s is that any delay on the part of a central bank 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.
Perhaps the RBA should take note!
As far as the Australian Government’s (understandable) anxiety regarding higher interest rates, it is probably the case that given the election cycle, it is best to get interest rate rises out of the way more quickly rather than draw them out (“death of a thousand increases”). If prior RBA prevarication, combined with a potentially challenging inflation environment requires the RBA to slam the brakes later in the cycle resulting in an even greater dislocation in activity and employment then that might create political (and not just economic) challenges for the Government.
As for the UK, the risk now is that scale of rate hikes the BoE must now visit on the UK economy to contain inflation mean that the extent of any future dislocation in activity growth and employment will be greater than need have been.
And the Conservatives hopes of clinging to power grows more remote.
Fed minutes point to a “pause”… perhaps a “peak” as FOMC members express different views on the need for further policy rate hikes, but “higher for longer” remains the guiding mantra
Last night’s release of the minutes from the Fed’s Federal Open Markets Committee (FOMC) meeting concluding on 3 May suggest that a “pause” in the rate hiking cycle is likely (but some way from a given) as FOMC members expressed different views on the need for further policy rate hikes.
The minutes stated that “several participants noted that if the economy evolved along the lines of their current outlooks, then further policy firming after this meeting may not be necessary.”
However, “some participants commented that, based on their expectations that progress in returning inflation to 2 per cent could continue to be unacceptably slow, additional policy firming would likely be warranted at future meetings.” The minutes added that “many participants focused on the need to retain optionality” going forward.
While that admits the possibility that the next move may be a cut, the minutes imply that the Fed view would be that any rate cut will be later than markets anticipate given that inflation is not tracking at a pace any faster than embodied in current Fed forecasts. In that context, the minutes suggest that the Fed officials will continue to espouse the “higher for longer” mantra regarding the policy rate and keep open the option of a further hike.
I expect the Fed will pause at the June meeting. Last week, Fed Chair Powell cited the lagged effects of the tightening to date as reasons why the Fed might “pause” and give their policies time to work.
Measures of the “inflation pulse” from the April CPI certainly suggests that the peak in inflation is behind us but that it nevertheless remain elevated.
The 3-month annualised core CPI was 5.1 per cent in April, unchanged from March and still some above the recent trough of 4.3 per cent in December. More encouraging was the fall in the 3-month annualised Cleveland Fed trimmed-mean measure to 4.2 per cent in April (the lowest level since May 2021) and down from 5.2 per cent in March.
The big question regarding future inflation has been over the trajectory of services inflation.
Here, there was some evidence of better news. The 3-month annualised rate of services inflation fell to 4.2 per cent, the lowest since October 2021.
As mentioned, despite somewhat better news on the services front, the minutes indicate that at a minimum overall progress is not of a sufficient magnitude to effect a change in the Fed’s “higher for longer” path for the policy rate. The bond market despite tempering its expectation of policy rate cuts still expects close to 40 bps of cuts in the second half of this year and more than 100bps in the next 12 months. That prognosis is not totally implausible but in my assessment is certainly located at one end of the risk spectrum and is still some distance from the Fed’s prognosis.
That pricing represents a widespread expectation of an imminent and meaningful recession.
However, the Fed’s FOMC median forecasts have GDP growing at only 0.5 per cent this year and the unemployment rate rising to 4.6 per cent. That 0.5 per cent has already occurred in the Q1. That means the Fed is implicitly assuming no growth between now and year-end. That is not inconsistent with a shallow recession. That means it will take more than a shallow recession for the Fed to meaningfully change course.
As I have previously remarked, 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.
Hence the minutes reaffirmation of the Fed’s emphasis continuing to be on the vanquishing of inflation and that, accordingly, market hopes of policy easing remain overstated even if the prospect of further hikes are receding.
US debt ceiling political pantomime continues as talks resume overnight
US political dysfunction has been firmly established as the “new normal”.
As the early June “x date” for when the Treasury could run out of funds approaches, US political, leadership continues to fiddle while money burns!
For almost a week there have been occasional signs that a bipartisan debt deal may be reached avoiding a government shutdown and US debt default.
History of course tells us that brinkmanship is the order of the day with such negotiations even if a deal is more likely than not to be reached at the 11th hour.
That means there is still room for a few bad headlines before a deal is finally reached.
My suspicion is that the current dispute is probably one of the reasons behind the difference in view between bond market pricing on the one hand and Fed communication on the other.
Bond markets continue to price aggressive easing from the Fed while the Fed itself communicates a “higher for longer” characterisation of the policy rate.
Obviously whether the US government falling into technical default is a binary outcome and portfolio positioning around it is accordingly complicated.
In the past, disputes of this nature have been resolved before the onset of “disaster” but not without some intensification of anxiety in markets. My suspicion is that it remains the appropriate precedent for the current episode. That seems to be the message coming from the early resumption of talks overnight.
A difficulty in looking at past episodes is that the economic backdrops in each of every similar episode was different. Indeed, none of them resembled the current one of “stickiness” in inflation.
However, given that the US political class seems intent on plumbing new depths of dysfunction an alternative drawn-out circumstance leading to technical default and ongoing political wrangling cannot be ruled out.
Conjecture around what takes place should the US approach technical default can be garnered by looking at similar previous episodes. Some insight can also maybe had from surveys of fund managers on likely responses of asset classes in the event of technical default.
The following stylised responses are derived from broker research / surveys.
- US Treasury yields are expected to fall and have generally done so around previous episodes of a similar nature (the exception was the 1st Trump shutdown when the Fed had just enacted a policy rate hike, albeit the last one for that cycle). A JP Morgan survey of 123 institutional investors found that 61 per cent of respondents expect 2-year yields to fall by an average of 18bp, while 67 per cent of respondents expect 10-year yields to fall by an average of 22 bp.
- The USD generally falls. The same JP Morgan survey found that 78 per cent of respondents see the USD weakening by an average of 2.6 per cent versus the JPY and the CHF. USD weakness versus the EUR is also anticipated but not to the same degree.
- JP Morgan didn’t survey likely equity market responses but found that 99 per cent of respondents respectively expect wider high-grade credit spreads with the IG CDX (investment grade credit default swap index) spreads expected to increase by an average of 44 bps. That would in general be consistent with “risk-off” equity weakness. (However, NAB strategists found that in the one month leading up to similar episodes in the past, equity performance was mixed, probably reflecting some differences in prevailing economic backdrops.)
What previous episodes seem to suggest is that there were periods of intense risk aversion and heightened volatility that in large measure proved temporary after the crises were substantially resolved. Thereafter, long-standing trends in various asset classes generally asserted themselves.
Should a positive tone of negotiations emerge one might reasonably anticipate the opposite of the aforementioned stylised responses.
In a sense what the broker research implies (and it is far from definitive) is that investors might consider some short-term hedging strategies ahead of the prospect of some intensification of risk aversion in markets but shouldn’t be persuaded to alter their long-term views – whatever they are.
By Stephen Miller, investment strategist
