Stephen Miller
US CPI: (maybe?) not enough for a July “pause” but it will be “one and done”
The June consumer price index (CPI) report indicates that inflation has meaningfully turned and that, accordingly, the Federal Reserve (Fed) is within sight of the end of the tightening cycle. In all likelihood the outcome is not enough for the Fed to enact one more 25 basis point (bp) increase when it next meets on 25-26 July (although that is not certain), but the best guess now must be that the path for the Fed from hereon in the cycle is “one and done”.
Any policy rate cuts, however, are well into 2024 and despite the relatively good news on inflation, I expect the Fed to retain its “higher for longer” mantra.
Headline inflation fell to 3.0 per cent from 4.1 per cent in May and while that largely reflects base effects from falls in energy prices, it was better than markets had anticipated. Core CPI fell to 4.8 per cent from 5.3 per cent from in May, its lowest since November 2021.
Moreover, the June CPI report indicates that progress in getting inflation down may be tracking at a faster pace, albeit ever so slightly, than embodied in the most recent Fed forecasts.
Measures of the ‘inflation pulse’ are indicative that peak inflation is behind us, and meaningfully so.
The 3-month annualised core CPI was 4.1 per cent in June, down from 5.0 per cent in May and the lowest since September 2021. Even more encouraging was the fall in the 3-month annualised Cleveland Fed trimmed-mean measure to 2.8 per cent in June, the lowest level since March 2021.
The big question regarding future inflation has been over the trajectory of services inflation. Here, there was also good 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 3.2 per cent, again the lowest since September 2021.
Nevertheless, given the nature of Fed communication since the June meeting it is difficult to see the Fed eschewing a further policy rate increase when it meets in late July. However, such an increase will be framed as ensuring the vanquishing of inflation and the subsequent 5.25 – 5.50 per cent target would almost certainly represent the peak policy rate for the current cycle.
The June CPI report was more than just slivers of good news on inflation. Accordingly, with the US 10-year bond yield close to 3.90 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 (or more) 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 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.
Despite a stubborn refusal of the data to comply, the market commentariat has been forecasting a recession for nigh on 18 months.
Of course, recession remains the big question.
However, with inflation containment within reach, the markets may begin to contemplate the notion that the Fed could successfully “thread the needle” and engineer a relatively benign disinflation (so-called “immaculate disinflation”) without an excessive dislocation in activity and employment – a ‘Goldilocks’ scenario.
That rarely happens, but…?
RBNZ stands pat; Bank of Canada goes again; RBA…?
Reserve Bank of New Zealand
As expected, the Reserve Bank of New Zealand (RBNZ) held the policy (official cash) rate (OCR) steady at 5.5 per cent at its meeting yesterday. In doing so, however, the RBNZ noted that for inflation to return to within the target range, the policy rate would need to remain at a restrictive level for some time.
In its most recent projections in May, the RBNZ forecast the benchmark rate would stay at 5.5 per cent until the third quarter of 2024.
The decision to “pause” was not a surprise. Indeed, as the Bank itself noted “monetary policy in New Zealand reached a more restrictive level earlier than in many other economies”.
The RBNZ was one of the first central banks to respond to price pressures emanating from, inter alia, the pandemic and (with the benefit of hindsight) the excessively stimulatory policies that followed in its wake and their tardy withdrawal. These were exacerbated by the Russia / Ukraine conflict.
Other central banks, including the Reserve Bank of Australia (RBA) were slower out of the gate.
Bank of Canada
Like the RBNZ, the Bank of Canada (BoC) also presided over a more muscular approach to the vanquishing of inflation.
However, in the wake of an apparent deterioration in the inflation outlook, the BoC increased the policy rate a further 25bps at its meeting overnight to take the policy rate to 5 per cent. This followed an increase of 25bps at its last meeting in early June. The BoC had left rates unchanged at meetings in April and March.
In the accompanying monetary policy report, officials forecast inflation will stay around 3 per cent for the next year before gradually declining to the 2 per cent target in mid-2025. This was two quarters later than previous projections and probably accounts for the decision to increase the policy rate overnight.
Beside a commitment to remaining “resolute” in its commitment to returning inflation to the 2 per cent target, the Bank provided little guidance on its future plans.
In one sense, given some lingering anxiety over inflation and is apparent “stickiness”, that is not surprising. However, what might surprise some Australian observers is how much lower Canadian trimmed-mean inflation is at 3.8 per cent (compared with 6.6 per cent in Australia) and how high the policy rate went to get it there (5 per cent in Canada versus the current 4.1 per cent in Australia).
Reserve Bank of Australia
In an address to the Economic Society of Queensland, current Reserve Bank of Australia
(RBA) Governor Lowe noted that he had “a completely open mind” on the path for the policy rate in Australia.
That may be so, but it is hard to escape the conclusion that more policy rate rises will be needed in order for the central bank (and others) to establish any confidence that inflation is contained to same extent as in the US or Canada. The comparisons noted above between the more cautious – some might say overly cautious – approaches of the RBA compared with the BoC are notable.
Even with forecast of tepid growth, the most recent quarterly Statement on Monetary Policy (SoMP) does not forecast inflation getting back to the top of the current 2 to 3 per cent target range until mid-2025. That reflects an unusually high tolerance of inflation compared to other developed country central banks. 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.
And even with Governor Lowe’s stated “open mind”, that means “live” meetings between now and year-end.
My view is that further increases in the policy rate are more likely than not.
The Fair Work Commission’s (FWC) recent wage decision will indubitably increase price pressures and just as indubitably increase pressure on the RBA for further policy rate increases. The wage increases awarded by the FWC are digestible in times of reasonable productivity growth, but the most 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 Statement following the 4 July decision noted that “at the aggregate level, wages growth is still consistent with the inflation target, provided that productivity growth picks up.” (My emphasis).
That is a big “if”!
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.
This is at a time when the RBA has been a “laggard” when it comes to tightening and where Australia’s relative inflation performance has been slipping.
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 reach at least in the “high 4s”, implying at least another two 25bp policy rate increase 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.
Turning an eye to the 1 August meeting, the likelihood of an increase is critically dependent on what the June quarter CPI (released on 26 July) reveals, and further assessment of the inflation pressures spawned by the FWC decision.
A trimmed CPI mean outcome greater than the current RBA forecast of 1.1 per cent quarter-on-quarter or 6.0 per cent annual likely means a further increase. The recent NAB survey revealed accelerating labour costs and retail prices in June that imply upside risks to the RBA inflation forecasts for the June quarter and beyond as the inflation consequences of the FWC decision ripples through the economy.
By Stephen Miller, investment strategist