Fed Chair Powell maintains the “pause not a peak” mantra and the RBA’s decision to increase the policy rate was “finely balanced”
Stephen Miller
In his semi-annual report to Congress Federal Reserve Chair Powell reiterated the main themes from his press conference last week following the Federal Reserve’s decision to “pause” the policy rate hike: that despite the “pause” the Federal Reserve (Fed) expects it will need to raise the policy rate further later in the year to contain price pressures.
He did add, however, that the Fed has some time to assess the requirement for higher policy rates suggesting that while “earlier in the process, speed was very important…it is not very important now.”
Powell noted that “nearly all FOMC participants expect that it will be appropriate to raise interest rates somewhat further by the end of the year,” but did note that the timing and perhaps magnitude of future policy rate increases will be data dependent.
On the observed tightening of credit conditions, Powell noted that “the economy is facing headwinds from tighter credit conditions for households and businesses, which are likely to weigh on economic activity, hiring, and inflation,” but added that “the extent of these effects remains uncertain.” Powell noted that the biggest US lenders were “very well capitalised”.
It seems then that while not unaware of tightening credit conditions and alert to financial stability issues, that for the time being inflation concerns trump financial stability concerns.
Financial markets are now pricing around a 70 per cent probability that the Fed will lift its policy rate by 25 basis points when it meets on 25 to 26 July.
The Fed’s retention of its “hawkish” disposition may in some measure be a device to forestall a further easing in financial conditions. The US 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 and how far the Fed is from contemplating any cut in the policy rate. Markets have more recently tempered their difference of view with the Fed, and it may be that the Fed and Powell are concerned not to excite too much market exuberance attendant to a policy rate “pause”, hence the maintenance of the “hawkish” tone.
I harbour some doubt as to whether the Fed will deliver on its projected rate increases.
The most recent May consumer price index (CPI) inflation data suggested meaningful (if somewhat grudging) progress on inflation.
Headline inflation fell to 4.1 per cent from 4.9 per cent in April largely reflecting base effects from falls in energy prices. Core CPI remains elevated at 5.3 per cent from 5.5 per cent in April.
However, measures of the ‘inflation pulse’ are indicative that peak inflation is behind us, and potentially meaningfully so. The 3-month annualised core CPI was 5.0 per cent in May, down from a peak of 7.1 per cent in June 2022, while the 3-month annualised Cleveland Fed trimmed-mean measure fell to 3.2 per cent in May, down from a peak of 7.8 per cent in July 2022 and the lowest level since March 2021.
The big question regarding future inflation has been over the trajectory of services inflation. Here, there was also some better news. The 3-month annualised rate of services inflation fell to 3.4 per cent, the lowest since September 2021. While the annual rate of services ex-rent of shelter fell to 4.2 per cent, its lowest since December 2021.
It was the “stickiness” in services inflation that has hitherto kept the FOMC on its moderately hawkish tack. Progress on that front may be grudging, but it is progress, nevertheless.
Given the slivers of good news on inflation, and with US 10-year bond yields around 3.75 per cent, it is not a stretch to posit that bonds (government and corporate) offer investors a modestly attractive enough yield without the prospect of significant capital losses. In other words, it may be time to “dip a toe in the water” on bond exposure.
A proximate stabilisation in bond yields may be good news for US equity markets, representing as it does the abatement of what has in the past been a significant valuation headwind. However, while equities benefit from stabilising bond yields, the question remains whether earnings estimates have appropriately priced the cyclical downside. Recession remains the big question and the key risk upon which investors continue to focus.
However, even given the “pause not a peak” mantra, the Fed is now close to the completion of the tightening cycle without there yet being evident any extreme dislocation in activity or employment. That has seen markets tentatively contemplate a more optimistic outcomes that involve the Fed successfully “threading the needle” and engineering a relatively benign disinflation without an excessive dislocation in activity and employment – so-called ‘immaculate disinflation’ or a ‘goldilocks’ scenario.
That rarely happens, but…?
RBA June Board meeting minutes: decision to increase the policy rate was “finely balanced”
The minutes of the Reserve Back of Australia (RBA) June Board meeting revealed that the decision to increase the policy rate was a finely balanced one. Market’s interpreted the minutes as indicating a slightly less “hawkish” disposition on the part of the RBA Board and while it is probably true that the RBA will “skip” a policy rate hike at its 4 July 4 meeting, one should be wary of the probability of further hikes later in the year.
The RBA will likely “skip” July, allowing it further time to assess the impact of successive policy rate hikes in May and June. The greater frequency of RBA Board meetings compared with their developed country counterparts (monthly as opposed to every 6 weeks) suggests a “skip” is not unreasonable, particularly given the lags with which monetary policy operates. (The RBA will go to 6 week cycle with the implementation of the recommendations from the recent RBA review – an RBA fit for the future.)
However, implicit in the minutes is the notion that the RBA is close to the limit of its tolerance in terms of the expected timeframe attaching to the return of inflation to target. The most recent quarterly Statement on Monetary Policy (SoMP) does not have inflation getting toward the top of the current 2-3 per cent target range until mid-2025. Indeed, the RBA review recommended a greater focus on the mid-point of the 2 to 3 per cent target range rather than simply being content with being in the range itself. At the margin that may encourage an even tighter ‘on average’ stance of monetary policy.
That means “live” meetings between now and year-end with further increases in the policy rate is almost inevitable.
The decision to increase the policy rate at the June meeting appears to reflect in part an attempt to quarantine the consequences stemming from the recent Fair Work Commission (FWC) to award an effective 8.6 per cent increase in the minimum wage and a 5.75 per cent increase in award wages. That decision will indubitably increase price pressures and just as indubitably increase pressure on the RBA for further policy rate increases. Such wage increases are digestible in times of reasonable productivity growth, but the recent national accounts showed productivity growth at an abject -4.5 per cent over the past year, and unit labour cost growth (the most relevant labour cost gauge for inflation) is at a whopping 7.9 per cent – and this was before the FWC decision.
The Governor’s statement post the June meeting omitted previous references to inflation expectations being “well anchored”. The June meeting minutes noted that “…members discussed the possibility of implicit indexation of wages to past high inflation and the potential for this to become widespread. Similarly, members observed that some firms were indexing their prices, either implicitly or directly, to past inflation. These developments created an increased risk that high inflation would be persistent…”. (My emphasis.)
Recent changes in the regulatory environment, particularly in relation to the wage-setting and the industrial relations framework run the risk of entrenching higher inflation in Australia compared to elsewhere, particularly as they weaken the link between productivity improvements and real and nominal wage growth.
These are domestic developments that will be of some concern to the RBA as it wrestles with an already forecast elongated return of inflation to target.
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. The FWC decision and the “unintended consequences” of labour regulation may make that path an even narrower one.
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).
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 to be in the “high 4s”, implying at least another two 25 basis point (bp) policy rate increases between now and year-end to bring inflation back to the 2 to 3 per cent target zone within an acceptable timeframe while at the same time 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 may be on the agenda of the July meeting but a third consecutive monthly increase looks a ‘bridge too far’.
It will likely await the June quarter CPI (released on 26 July 26) and further assessment of the inflation pressures spawned by the FWC decision.
UK inflation exceeds expectations…again! Adds to Edgbaston Ashes Test defeat misery – Bank of England (BoE) to ponder a 50bp policy rate rise?
After losing the first Ashes Test, things just got worse for the UK with (another!) higher than expected consumer price index (CPI) inflation print for May.
Headline inflation was unchanged 8.7 per cent, higher than the 8.4 per cent expected.
Core inflation came in at 7.1 per cent versus 6.8 per cent expected.
Last month the 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.” Three consecutive months of greater than anticipated increases in the CPI means there is now a clearly visible “smoking gun” of evidence.
The May CPI numbers almost certainly mean a further increase of at least 25 bps in the policy rate at the scheduled BoE meeting this evening. A 25bp increase will take the policy rate to at 4.75 per cent. Indeed, given the magnitude of the data surprise, and coming after the March and April figures also surprised on the upside by a considerable margin, it may be that discussions of a 50 bp increase make tonight’s BoE agenda. Peak policy rate pricing is now close to 6 per cent by the end of the year.
Of course, the BoE 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 fleeting Truss Government indisputably played major roles, including adding unnecessary inflation pressure.
But at various times through 2022, the BoE created an impression that it was reluctant to embrace a frontline role in containing inflation. Nor did it seek to avail itself of opportunities to ‘lean in’ to inflation pressures generated by poorly designed Government policies. 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.
The UK inflation report stands in contrast to the (admittedly grudging) progress in the US and Canada and even Europe and New Zealand where after a stumbling start those central banks embraced an aggressive and unambiguous focus on inflation. There is evidence that approach is close to achieving its aims in the US and Canada where the inflation focus has been unambiguous, at least since very early in 2022.
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.
Hopefully the RBA (and Government) have noted the costs associated with the BoE approach.
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 grow even more remote.
By Stephen Miller, investment strategist
