Stephen Miller

Yesterday’s April Labour Force Report was on the surface a little softer than anticipated but is not sufficient to move the dial for the RBA from a setting of “inflation alert”. Employment fell marginally and the unemployment ticked up to 3.7 per cent which is above the RBA’s May Statement on Monetary Policy (SoMP) June forecast of 3.6 per cent. That may be a little troubling, but is probably offset by a significant increase in total hours worked, which were up 2.6 per cent in the month, indicating labour markets are still functioning at maximum capacity (perhaps beyond).

Coming after yesterday’s March quarter Wage Price Index (WPI) Report showing annual growth of 3.6 per cent in the March quarter wage price index (WPI), it is difficult to see any elevation of inflation concern held by the Reserve Bank of Australia (RBA).

In that context, given that the minutes of the May meeting indicated that the decision to increase the policy rate was “finely balanced”, the WPI and Labour Force are not sufficient to push the RBA to consider a further increase in the policy rate at the meeting scheduled for 6 June.

However, neither are they sufficient to sway the RBA from its “inflation alert” stance and neither do they rule out further increases in the policy rate later in the year, particularly given upside risks around inflation and wage / unit labour cost growth.

Perhaps of some significance is that the annual increase in the WPI was the highest such increase since September 2012. Including bonuses, the annual rate of increase is 3.8 per cent which is the highest since March 2011 (4.1 per cent for private sector workers, the highest since December 2008).

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. There is some conjecture that the WPI is not entirely effective in capturing de facto wage increases that occur via “classification creep”. The national accounts measure 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: 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 before 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 schedule

The period ahead does contain a number of elements that might upset any benign view about how inflation might return to target.

The Fair Work Commission (FWC) has to conduct its 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 framework, also run the risk of entrenching higher inflation in Australia compared to elsewhere.

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 2-3 per cent target zone within an acceptable timeframe while minimising the dislocation in activity growth and employment. However, barring an unanticipated spike in either the Monthly CPI indicator or national accounts wage / unit labour cost measures, the next policy rate hike window will probably not occur until the 1 August Board meeting after the June quarter CPI release on 26 July.

US debt ceiling disputes – some observations

The US debt ceiling dispute continues to bubble away in the background. Earlier this week US Treasury Secretary Yellen again reiterated the 1 June “x date” for when the Treasury could run out of funds, although the actual date could be a number of days or even weeks later than this.

However, there were some positive signs from negotiations overnight with comments from President Biden and House Speaker McCarthy raising hopes a bipartisan debt deal may be reached avoiding a government shutdown and US debt default. President Biden said he was confident “we’ll get the agreement on the budget and that America will not default” while House Speaker McCarthy said he remained hopeful a deal could be reached.

History of course tells us that a deal is more likely than not to be reached on the 11th hour, suggesting there is still room for a few bad headlines before a deal is finally reached.

My suspicion is that the current dispute is probably the key reason 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 Federal Reserve (nearly 150 basis points over the coming 12 months) while the Federal Reserve (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 remains the appropriate precedent for the current episode. Last night’s positive sounding developments reinforce that view.

A difficulty in looking at past episodes is that the economic backdrops in each 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 be made 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 1^st 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 18 basis points (bps), while 67 per cent of respondents expect 10-year yields to fall by an average of 22bp.
• 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.

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 the positive tone of negotiations continue 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

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