RBA minutes, Bullock commentary and bond markets waiting for policy rate cuts like waiting for Godot

RBA minutes, Bullock commentary: a December policy rate hike looks unlikely. Governor’s communication well framed

Yesterday’s Reserve Bank of Australia (RBA) Board meeting minutes from the 7 November  Board meeting and comments from RBA Governor, Michele Bullock, indicate that the Board retains a moderate tightening bias. However, it is clear that the Board also seeks maximum optionality going forward by making that tightening bias conditional on key data and future risk assessments. The key phrase in the minutes was “whether further tightening of monetary policy is required to ensure that inflation returns to target in a reasonable timeframe would depend on how the incoming data alter the economic outlook and the evolving assessment of risks”. (my emphasis)

The minutes affirmed a tightening bias by stating that forecasts were predicated on “one to two increases in the cash rate over coming quarters” (my emphasis).

This was reinforced overnight in comments from Governor Bullock that task of bringing inflation back to target would be a protracted one and further that “the remaining inflation challenge we are dealing with is increasingly homegrown and demand driven” and “a more substantial monetary policy tightening is the right response to inflation that results from aggregate demand exceeding the economy’s potential to meet that demand”.

That suggests that after an extended period where its tolerance for an elongated return of inflation to target has been much greater than most other developed country central banks, the tolerance well is pretty dry.

In a highly uncertain global and domestic environment BOTH the tightening bias and the articulation of that optionality / conditionality is entirely appropriate.

The balance of risks is that inflation may be even more intractable. As well as being predicated on perhaps another rate increase, the minutes note that inflation forecasts assume “that productivity growth would recover over the year ahead”. That is a critical assumption.

Wage increases are digestible in times of reasonable productivity growth. However, productivity growth in Australia has been abjectly poor and even with relatively modest wage growth, the most recent (if dated) figures show unit labour cost growth (the most relevant labour cost gauge for inflation) is running at over 7 per cent per annum.

By contrast, the current annual rate of unit labour cost growth in the US is 1.9 per cent with the difference mostly attributable to productivity growth.

The interplay between productivity and wage growth are domestic developments upon which the RBA will cast a keen eye.

Central bankers around the world have also remarked on structural sources of “stickiness” in global inflation. 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. An unwillingness to tackle housing supply may entrench this problem.

As extant as these risks are, there are some going the other way with risks that any slowdown and attendant disinflation obviates the need for further monetary tightening.

Important in determining the potential timing of any further policy rate hike will be the September quarter national accounts which (a little unhelpfully) are released a day after the RBA Board’s December meeting on 6 December. They are important not just because of the conventional measures of economic activity growth that they provide but also for wage, productivity, and unit labour cost indications. Finally, the December quarter consumer price index (CPI) on 31 January also looms as a key staging post in determining whether another policy rate hike is appropriate.

Also important, will be unfolding developments in China which were given explicit reference in the Governor’s November Statement and which continue to remain troublesome.

That probably means that the next window for a policy rate hike will not occur until the February RBA Board meeting on 6 February, and then only if unit labour cost growth and inflation refuse to show indications of meaningful decline or prospects thereof.

Finally, in my view Governor Bullock has applied herself well to the framing and nuancing of RBA communication.

Financial markets crave guidance from central banks. In their craving for such guidance, however, they often lack appreciation of the limitations on central banks in the provision of such guidance. That is not simply the case in the current circumstance where “known unknowns” are particularly manifest but also in normal circumstances where “unknown unknowns” are omnipresent.

In this context, Governor Bullock’s articulation of the conditionality in any RBA guidance and of the balance of risks is noteworthy and appropriate.

Too often, central bank communication has ignored this and attempted to sate the markets’ craving.

Moreover, her direct message to the broader community regarding the inflation challenge is also welcomed by providing a secure anchor for inflation expectations.

It was failures of nuance and a lack of emphasis on conditionality that may have blotted the previous Governor’s copybook.

The incoming Governor has so far avoided that mistake.

FOMC minutes: for bond markets waiting for policy rate cuts like waiting for Godot

Since the Federal Reserve (belatedly) commenced increases in the policy rate in March 2022, the US bond market has been on recession alert (or alarm?). The Federal Reserve (Fed), however, has exhibited a more sanguine disposition.

To be fair to the bond market, the circumstances where the Fed has successfully “threaded the needle” and engineered a relatively benign disinflation (so-called “immaculate disinflation”) without an excessive dislocation in activity and employment – a ‘Goldilocks’ scenario – are rare. Historically, episodes of monetary tightening generally end in recessions, quite frequently occasioned by the consequences of that monetary tightening. That reflects just how hard it is to fine tune the business cycle through the manipulation of the stance of monetary policy.

On the other hand, a more critical narrative might suggest that bond market participants ignored the context of the current tightening cycle: that it was occurring against a background of an inflationary shock and where levels of monetary accommodation were at historically unprecedented levels. That may reflect that many market participants had little experience with any meaningful inflation shock and lacked an appreciation of just how difficult it is for central banks to effectively contain such a shock. The most recent precedents date back to the 1970s.

As the self-described “aged” 1970s ruminator, Niall Ferguson, wrote he “keeps having to remind people that the dream of pain-free disinflation was a recurring delusion of the 1970s”.  In other words, the lesson from the 1970s is that any delay on the part of a central bank in enacting a coherent and firm response to an inflation threat only heightens the risks down of a more damaging macroeconomic dislocation in terms of activity and employment down the track.

Nearly all central banks were late out of the gates in recognising that the current inflation episode was more persistent, in part because of the tailwinds provided by excessively extended period of monetary accommodation that occurred in the wake of the pandemic. But the Fed took an early corrective stance to rectify the errors of its earlier prevarication.

The Federal Open Markets Committee (FOMC) meeting minutes from the meeting concluding on 1 November were quite well balanced. While all officials noted that the FOMC was in a position to “proceed carefully”, they all thought it was appropriate to keep rates restrictive “for some time until inflation is clearly moving down sustainably” (my emphasis). Moreover, most officials continued to see upside risks to inflation. That meeting took place when US 10-year bond yields were close to 5 per cent; they are now some 50 basis points lower than that. So while officials noted that financial conditions had tightened significantly, and that “persistent changes in financial conditions could have implications for the path of monetary policy”, financial conditions are now significantly eased from those that prevailed at the time of the meeting.

All said and done, the tone of the FOMC minutes suggests that the Fed tightening cycle is likely in abeyance – probably indefinitely.

That was underscored by a somewhat more benign October consumer price index (CPI) report.

However, the report is not quite as benign as the market would have it with measures of the ‘inflation pulse’ revealing some ongoing “stickiness” in inflation.

The 3-month annualised core CPI was 3.4 per cent in October, up from 3.1 per cent in September and 2.4 per cent in August. The 3-month annualised Cleveland Fed trimmed-mean measure rose to 3.8 per cent in October from 3.7 per cent in September and 2.9 per cent in August and was the highest since April this year. The Cleveland Fed median measure rose to 4.5 per cent from 4.0 per cent in September and 3.6 per cent in August.

The October report may also reinforce ongoing concern at the Fed regarding the “stickiness” of services inflation. The 3-month annualised rate of services inflation (or ‘pulse’) increased to 5.3 per cent, the highest since March.

Indications of ongoing “stickiness” will make Fed officials properly wary of declaring “mission accomplished” on inflation, hence the maintenance of the “high for longer” mantra. That was the key message from the FOMC minutes.

For the bond market then waiting for a policy rate cut may continue to feel like waiting for Godot.

That means that the Fed itself believes that it is a long way from contemplating any policy rate cuts – probably not until the second half of 2024. That is some distance from some of the more aggressive projections in the marketplace. In that context, it appears to me that the extent of easing currently priced into markets – while not implausible – implies a policy rate path through 2024 that is located at the low end of the risk continuum.

In other words, the policy rate is remains best viewed as at a “plateau” rather than a “peak”.