Stephen Miller

The Reserve Bank of Australia’s (RBA) decision to “skip” a policy rate increase at Tuesday’s meeting was certainly defensible.

The June quarter consumer price index (CPI) suggested that inflation as measured by the RBA’s favoured trimmed-mean measure, was tracking ever so slightly better than forecasted back in May. And while the labour market has exhibited particular resilience, there have been some indications of weaker activity growth, particularly given last week’s softer than anticipated June retail sales release and ongoing weakness from China.

But investors (and mortgage debtors) would be well advised to repress any inclination toward exuberance.

For one thing inflation remains elevated.

For another, despite a slightly better outcome for the June quarter CPI, the return of inflation to somewhere within the target 2-3 per cent band is even more elongated than forecast back in May, with that now not scheduled until “late 2025” (rather than the June quarter 2025 as forecast back in May).

That likely reflects an assessment from the RBA that the Fair Work Commission (FWC) wage review decision announced in early June has likely intensified inflation pressures. That decision takes effect from 1 July, so it wasn’t relevant to the June quarter CPI outcome.

That decision is likely to see inflation in Australia exhibit a greater degree of “stickiness” than in other developed country jurisdictions. This is not something that in my judgement is well understood by the market commentariat.

It is why Governor Lowe’s statement issued with the announcement of Tuesday’s decision noted again that “some further tightening of monetary policy may be required to ensure that inflation returns to target in a reasonable timeframe” adding that would “depend upon the data and the evolving assessment of risks”.

The RBA position already reflects an unusually high tolerance of inflation compared to other developed country central banks.

The FWC wage increases are digestible in times of reasonable productivity growth, but recently productivity growth has been extremely poor.

Tuesday’s statement 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.

These are domestic developments that should be of ongoing 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.

The RBA has also been a “laggard” when it comes to tightening and where Australia’s relative inflation performance has been slipping. This is true even after the better June quarter inflation report.

Despite a markedly better inflation performance both the Federal Reserve (Fed) and the Bank of Canada have chosen to tighten further.

In one sense, given some lingering anxiety over inflation and its apparent “stickiness”, that is not surprising. However, what might surprise some Australian observers is how much lower US and Canadian trimmed-mean inflation is at 4.9 per cent and 3.7 per cent respectively (compared with 5.9 per cent in Australia) and how high the policy rate went to get it there (a target of 5.25- 5.5 per cent in the US; a target of 5 per cent in Canada; versus the current 4.1 per cent in Australia).

The forgoing leads me to conjecture that barring an unforeseen rebound in productivity growth, the policy rate may well need to go higher in order to bring inflation back to the 2-3 per cent target zone within an acceptable timeframe while at the same time minimising the dislocation in activity growth and employment.

Let’s hope that for mortgage debtors the “skip” is not a prelude to a “trip” later in the year.

US: Fitch downgrade

Yesterday, US Government debt was downgraded from the top tier AAA to the next level AA+ by the Fitch ratings agency.

The move is an echo of a similar move from S&P around a decade ago.

As was the case then the move led to some intensification of risk aversion in markets, but I suspect the impact will be fleeting as more ‘fundamental’ influences on the pricing of US Treasury bonds (such as inflation, central bank action etc.) assert their dominant influence.

In making the announcement, Fitch stated that “[t]he rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to ‘AA’ and ‘AAA’ rated peers over the last two decades”.

While the timing is perhaps a surprise, it is hardly a shock. The abject performance of the US political class in the period since Donald Trump assumed the Presidency has been breathtakingly poor.

The internecine clashes over the raising of the debt ceiling are just one element of that abject performance that Fitch characterises as “the erosion of governance”.

On the policy front, the Biden Administration has also had its challenges, presiding over continuing large budget deficits that have not been wound in quickly enough in the post-pandemic period, and implementing a regulatory regime that in many respects resembles the failed approaches of the second half of the 1960s and the 1970s. Those measures wrought the moribund economic performance that marked those times. Aside from intractable deficits, these measures include protectionist measures under the guise of “industrial policy” and “national champions” that in substance are not that distant from similar measures first enacted by the Trump Administration.

Frustratingly, the only thing that the polar opposites of the American polity seem to agree on implementing populist solutions to complex economic problems that will compound poor economic performance. Again, a stark example of the “the erosion of governance”.

However, all said and done I do not believe that the downgrade itself will have much impact other than to focus attention on these matters which, in any case, are probably mostly reflected in current US bond yields.

The downgrades are not in the short-term, going to alter the ‘exorbitant privilege’ currently attaching to the US and its currency being the ‘world reserve currency’. It may have an impact over time, but it will be of the ‘slowest of slow drip’ variety.

While I am reluctant to unconditionally embrace the emergent ‘Goldilocks’ / soft landing narrative attaching to US financial markets, I suspect that any upward move in yields consequent on the downgrade may be a buying opportunity for US bonds. With the US 2 and 10-year bond yields close to 4.90 per cent and 4.00 per cent respectively it is not a stretch to posit that bonds offer investors a modestly attractive enough yield without the prospect of significant capital losses. In other words, the downgrade may effect an opportunity to “dip a toe (or more) in the water” on bond exposure.

Coming up: Bank of England to raise the policy rate 25bps to 5.25 per cent; US non-farm payrolls loom

Bank of England

Despite a better than anticipated inflation print for June, the Bank of England (BoE) is widely expected to increase the policy rate by a further 25bps to 5.25 per cent when it meets tonight.

Indeed, while the June core CPI was better than expected at 6.9 per cent (versus 7.1 per cent expected), inflation remains elevated, and that June result followed large upside surprises in both April and May.

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.

Mohamed El-Erian writing for Bloomberg this week makes this same point noting (correctly in my view) that the BoE’s job has been made immeasurably more difficult by:

• Stronger resistance to further real wage erosion among segments of the labour force, evidenced by the combination of the highest nominal wage growth and widespread industrial action.
• Disruptions in external trading relations post-Brexit that slow supply chains and make them less cost-effective.
• A lower degree of internal economic flexibility contributing to longstanding productivity challenges.
• Limited government support for supply-side enhancement in comparison with the efforts of the US and, to a lesser extent, the Eurozone.

However, El-Erian adds (curiously in my view) that it is “perplexing” that the BoE faces such challenges given it was (in his view) the first among its counterparts to acknowledge its mistake in characterising inflation as “transitory” and the first to initiate its rate-hiking cycle to combat high inflation.

I suspect that El-Erian wasn’t paying attention when BoE Governor Bailey in the middle of last year lamented that he felt “helpless” in the face of global price pressures, warning of an “apocalyptic” surge in the cost of food and added for good measure that he has “run out of horsemen” after the pandemic and the war in Ukraine.

Bailey further asserted that price increases were almost exclusively driven by supply shocks that couldn’t have been anticipated and that in any case it was “well established practice to accommodate supply shocks where they’re expected to be transient.” (My emphasis).

If the BoE was first among its peers, then certainly shuffled itself back in the field as it prevaricated in assuming a frontline role in fighting inflation. At least when the Fed and Chair Powell turned their attention to containing inflation, they were resolute in their focus, unlike the BoE. There is evidence that the Fed’s approach is close to achieving its aims. The UK and the BoE are some distance from that point.

In my view the BoE did not 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 lesson from the ‘70s is that any prevarication 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.

In this context, I expect that were the BoE to deliver 25bps tonight, that will not be the end of the cycle. The risk now is that scale of rate hikes the BoE must now place 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.

US June non-farm payrolls

The July US monthly non-farm payrolls report to be released on Friday will of course be keenly watched.

For much of the current tightening cycle, the bond markets have had a predilection for the Fed to commence an easing cycle much sooner than the Fed indicated or, indeed, now seems likely. However, there is a very real debate now about whether the Fed will follow through with a further policy rate hike in September as implicitly foreshadowed by the median “dot plot” released in June.

A weaker payrolls may reinforce the current tendency for markets to increasingly view the prospect of a further policy rate hike in September as unlikely.

The June report was satisfactory enough at a 209k increase in employment, and the unemployment rate was at a respectable enough 3.6 per cent. Wages growth (as measured by average hourly earnings) was a little above expectations at 4.4 per cent, but that hasn’t appeared to prevent progress on inflation appearing to run a little ahead of the Fed June forecasts.

As important as the payrolls data are, in the absence of a report a long way from expectations, it will be progress on inflation that will determine whether the Fed chooses to enact any further policy rate hike.

In this context, markets will likely be particularly exercised regarding the extent to which the July report reveals some tempering of wage pressure as well as focussing on conventional measures of employment growth and the unemployment rate. Decelerating wage growth would likely reinforce an emergent positive narrative regarding inflation abatement / ‘soft landing’ and a positive backdrop for financial markets (US credit rating hiccups notwithstanding.)

The consensus estimates for July non-farm payrolls are for an increase in employment of around 200k, an unchanged unemployment rate at 3.6 per cent, which is still close to a 50-year low, and for average hourly earnings to slow to 4.2 per cent annual growth.

The June Job Openings and Labour Turnover Survey (JOLTS) released on Tuesday was consistent with some softening of labour market conditions with job vacancies (openings) coming in at 9582k, little changed from the downwardly revised May number at 9616k (previously 9824k). US job openings continue to show a gradual downtrend with the June print the lowest level since April 2021, although they remain consistent with the soft-landing narrative.

Also important will be the employment component of the Institute for Supply Management (ISM) Purchasing Managers Index (PMI) for services, released tonight. That component rebounded into positive territory in June and is expected to remain there in July albeit by a lesser margin. The weakness in the employment component in the manufacturing PMI was noticeable, although manufacturing employment is less than 10 per cent of payrolls employment.

The ADP payrolls report released overnight showed a solid 324k bounce in employment and while a reasonable enough indicator, its record in foreshadowing month-to-month movements in the Bureau of Labour Statistics measure is mixed.

An outcome close to expectations for the aforementioned components of the non-farm payrolls report won’t move the dial for the Fed.

The real test comes next week with the release of the US CPI next week.

By Stephen Miller, investment strategist.

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