Stephen Miller
RBA skips, but has it stopped?
As expected, the Reserve Bank of Australia Board chose to “skip” a policy rate increase when it met on Tuesday.
Put simply, the “data dependence” criterion made the case for any increase in the policy rate at Tuesday’s meeting too difficult for the RBA to prosecute.
The Governor’s Statement noted that the “recent data are consistent with inflation returning to the 2–3 per cent target range over the forecast period.” (My emphasis)
However, the backward focus on recent data does little to assuage nascent anxieties that inflation in Australia will prove to be “sticky” enough to force the RBA’s hand later in the year or early next.
And that a rate rise in October was too difficult for the RBA to prosecute doesn’t mean that there is not a prosecutable case, one based on the data pipeline.
The Governor’s Statement appears to acknowledge this noting that “some further tightening of monetary policy may be required to ensure that inflation returns to target in a reasonable timeframe.”
The August monthly consumer price index (CPI) shows a reacceleration of inflation from July. Of some concern too would have been the “stickiness” evident in the services sector. That followed on from indications in the NAB Monthly Business Survey of some re-acceleration in wages and prices supported by other surveys indicating accelerating wage growth.
Were those trends to presage a similar reacceleration of wage and price pressures in the more lagged official Australian Bureau of Statistics (ABS) data then policy rate increases could well be back on the agenda as early as the next meeting on 7 November.
Based on the monthly CPI numbers, NAB economists issued a “naïve” forecast quarter-on-quarter increase for the September quarter trimmed-mean CPI of 1.0-1.1 per cent (circa 5 per cent annual), above the RBA’s 0.9 per cent. In my view, on the basis of the price and wage numbers in the NAB Monthly Business Survey there may even be upside risk to the NAB economists’ “naïve” forecast.
That puts a particular focus on the September and December quarterly official ABS wage and price measures.
There appears to be an emergent tendency for more wage increases to occur at the start of a new financial year, not the least reflecting the recent Fair Work Commission wage review decision that took effect from July 1.
In that context, RBA forecasts released with the August Statement on Monetary Policy (SoMP) may not adequately reflect the upside risks to inflation.
Those upside risks are put in stark relief by a continuing poor productivity performance. Even with relatively modest wage growth, according to the most recent national accounts data, unit labour costs (the most relevant labour cost gauge for inflation) are growing at over 7 per cent per annum. As the Governor’s Statement noted “wages growth … is still consistent with the inflation target, provided that productivity growth picks up”. (My emphasis)
In other words, the “future” data may well look different to the arguably fortuitous character of the “recent” data, leaving the way open for further policy rate hikes into year-end and beyond.
RBNZ: no change, but still some risk of a further policy rate hike
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 so doing, however, the RBNZ noted that “interest rates may need to remain at a restrictive level for a more sustained period of time.” This came after noting at the last meeting in August that there was some risk that it may need to raise the policy rate further to ensure inflation is adequately contained. Such a risk was reflected in projections from the RBNZ issued in August that show the average OCR rising to a peak of 5.59 per cent in mid-2024 before falling to 5.5 per cent by the end of that year. Those projections are not due to be updated until the next meeting on 29 November.
All said and done, the decision to eschew a policy rate rise was not a surprise. Indeed, as the RBNZ itself noted current policy settings “are constraining economic activity and reducing inflationary pressure as required.” In this context, the prospect of a further policy rate hike is best viewed as a risk to a central case that involves the current 5.5 per cent representing a cyclical peak, even if that 5.5 per cent persists for a considerable period.
Time to talk bonds?
Despite choosing to leave the policy rate unchanged at the last meeting, Federal Reserve Chair Powell noted that the Federal Reserve (Fed) was “prepared to raise rates further if appropriate and we intend to hold policy at a restrictive level until we’re confident that inflation is moving down sustainably toward our objective.”
This suggests that in the Fed’s view the policy rate is at best considered as approaching (or at) a “plateau” rather than a “peak”.
In the wake of that Fed decision, US 10-year bond yields rose to levels not seen since 2007. 2-year bond yields rose to levels seen only fleetingly since back in 2000.
Those moves have occurred despite meaningful progress on inflation. Indeed, Chair Powell noted at his post-FOMC meeting press conference that the “last three inflation readings were very good.” He added that the last jobs report was a “good example of what we want to see” and that further “as we approach the appropriate stance, risks are more two sided with the risk of over or under tightening becoming more equal”.
There is some proper residual concern regarding the “stickiness” of services inflation. And while Fed officials are properly wary of declaring “mission accomplished” on inflation, the totality of the economic data lean toward (admittedly not unambiguously) softer economic activity and softer labour markets and attendant progress on inflation that is in line with the Fed’s objective.
There are good reasons for the current ‘high’ level of US bond yields.
For one thing, the “neutral” interest rate appears to have risen from the abnormally low levels that applied post-Financial Crisis through to the end of the pandemic.
Certainly, the resilience of activity and the labour market during the current Fed tightening cycle is suggestive of the notion that the “natural” real growth rate has increased from that in the preceding 15 years or so, and that, accordingly, the “neutral” real interest rate should also have increased.
Other observers point to other emergent secular trends that might have pushed (and continue to push) the “neutral” real interest rate upwards: larger government deficits; investment demands on the savings pool from clean energy investments; and boomer retirees de-accumulating savings.
But what about inflation? That most of the increase in bond yields is explained by an increase in real yields, suggests that the Fed has successfully contained inflation pressures and expectations thereof by aggressively increasing the real policy rate.
But there are 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).
That means to keep inflation, and more importantly inflation expectations, anchored central banks everywhere will need to maintain higher real policy rates and real bond yields need to stay “high”. If markets lose faith in the ability of central banks to adequately meet these challenges that might lead to higher inflation premia leading to somewhat higher 10-year bond yields. This another reason the Fed remains particularly exercised to keep on top of inflation expectations.
So why US government bonds in a portfolio?
In short, the answer is that the prevailing level of yields and the policy rate also opens the way for the Fed to respond to a crisis, enabling bonds to potentially re-assume their sometime role as a mitigant to risk-averse sentiment.
Yes, there are upside risks in the form of unanchored inflation expectations, or even higher real yields, but they are arguably symmetric with downside risks associated with a sharper than anticipated slowdown. At currently prevailing yields it is not a stretch to posit that bonds offer investors a modestly attractive yield without the prospect of significant capital losses.
It has been sometime since bonds were able to deliver these diversifying qualities to portfolios. And it is these diversifying qualities (along with reasonable yields) that are the most attractive element of bonds in a portfolio, not the prospect of significant capital gains.
Coming up: US September non-farm payrolls
The September US monthly non-farm payrolls report to be released on Friday will of course be keenly watched.
The most recently issued Fed “dot plot” implies at least further increase in the policy rate this year. Moreover, markets have marched US bond yields substantially higher since the last Fed meeting, in part reflecting concerns related to the “stickiness” of inflation and an attendant hawkish Fed.
A stronger payrolls report might reinforce the current tendency for bond yields to go higher. Conversely, a weaker report may lead to a rapid re-evaluation of that likelihood.
Fed Chair Powell characterised the August report as a “good example of what we want to see.” The report revealed a 187k increase in employment, while the unemployment rate rose sharply to 3.8 per cent. Wages growth (as measured by average hourly earnings) was at a respectable enough 4.3 per cent.
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 encourage a more positive narrative on inflation abatement and a more positive backdrop for financial markets and vice versa.
The consensus estimates for September non-farm payrolls are for an increase in employment of around 165k, a slight fall in the unemployment rate to 3.6 per cent, and for average hourly earnings to slow to 4.2 per cent annual growth.
The August Job Openings and Labour Turnover Survey (JOLTS) report released on Tuesday indicated a surprising degree of strength in the US labour market.
Also important was the employment component of the Institute for Supply Management (ISM) purchasing managers index (PMI) for services, released overnight. That component remained in expansionary territory, albeit by a lesser margin. In somewhat of a surprise the employment component of the manufacturing PMI moved from slightly contractionary to slightly expansionary.
The ADP payrolls report released overnight showed a marked softening with employment growing only 89k (versus an expected 150k). While a reasonable enough indicator in and of itself, its record in foreshadowing month-to-month movements in the Bureau of Labor 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 but might be enough to assuage recent jittery markets.
The real test comes next week with the release of the September US CPI next week.
GSFM investment strategist Stephen Miller.