Stephen Miller
January’s US consumer price index (CPI) is a reminder that the challenges around the “last mile” in returning inflation to target are daunting. I suspect that the Federal Reserve (Fed) was aware of those challenges. The bond market less so – as has been the case throughout this post-pandemic inflation cycle.
In the last couple of years, bond market participants appear have under-appreciated just how daunting is the Fed’s battle to contain inflation: 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.
It also possibly reflects a mistaken perception of the “normality” of the extraordinarily low interest rates that persisted through the period from the Financial Crisis through to the end of pandemic.
In any case, the January inflation report may shake that complacency regarding the likely course of rates and bond yields.
US headline inflation rose by 3.1 per cent over the year to January, compared with an expected 2.9 per cent, while US core (ex-food and energy) inflation rose by 3.9 per cent over the year compared with an expected 3.7 per cent.
Measures of the ‘inflation pulse’, however, emphasise ongoing and troublesome “stickiness” in inflation.
The 3-month annualised core CPI was 4.0 per cent in January (the highest since June), and up from 3.3 per cent in December and a trough of 2.6 per cent in August. The 3-month annualised Cleveland Fed trimmed-mean measure rose to 4.1 per cent in January from 3.2 per cent in December and was the highest since April last year. The 3-month annualised Cleveland Fed median measure rose to 5.3 per cent from 4.3 per cent in December, also the highest since April.
The January CPI 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 6.4 per cent, the highest since February 2023.
Such indications of ongoing “stickiness” will reinforce the current tendency of Fed officials to be (properly) wary of declaring “mission accomplished” on inflation.
That reticence may turn to more overt resistance if the trends in the January CPI are repeated in the core private consumption expenditures (PCE) price index, the Fed’s favoured inflation measure. That measure had shown a meaningful and significant deceleration. The 3-month annualised rate of growth in that measure) was at 1.5 per cent in December, below the Fed’s 2 per cent target. However, the January CPI report highlights a clear risk – even likelihood – of a re-acceleration of that measure.
Apart from a recognition of the difficulties in vanquishing inflation, another source of the Fed’s reticence to publicly embrace rate cuts of the order of magnitude priced by the bond market is that there has also been “over-achievement” on activity and employment growth. That shows little sign of abating and while ever that remains the case there will be some lingering anxiety at the Fed regarding the challenges around returning inflation to target.
I have spoken in the past of key global structural elements at work that will make that “last mile” even more daunting. 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 goods and labour markets is increasing in scope (leading to upward price pressures); and baby boomer workforce participation is declining (limiting labour supply and lifting wages).
The forgoing is likely to lead the Fed to retain a “high for longer” mantra, meaning that any policy rate cuts are well into 2024 – maybe not until the second half of 2024.
Inflation developments aside, 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 recent 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 US budget deficits; investment demands on the savings pool from clean energy investments; and boomer retirees de-accumulating savings.
Of course, these developments will not stop the Fed responding to any unanticipated downdraft in growth and attendant decline in inflation, but they serve as reminder to the bond market that the period from the Financial Crisis to the pandemic is the exception not the rule.
What might be asserted with some confidence is that even if the Fed hasn’t completely seen off the inflation threat, the prevailing levels of the policy rate and bond yields opens the way for the Fed to respond to a downdraft in growth, enabling bonds to potentially re-assume their sometime role as a mitigant to risk-averse sentiment.
Yes, there are certainly challenges around the “last mile” to the inflation target, 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.
But the lesson from the January CPI report is that absent a crisis leading to a downdraft in growth, the Fed may continue to test the faith of the bond market in terms of the Fed’s appetite to deliver rate cuts of the order of magnitude previously implied by the bond market.
RBA: a steady hand on the tiller
Last Tuesday’s inaugural post-Board meeting press conference from Reserve Bank Governor (RBA), Michele Bullock, and her later parliamentary testimony, contained a well-framed and appropriately nuanced message which (quite properly) gives the Board maximum optionality going forward.
Financial markets crave guidance from central banks. In their craving for such guidance, however, there is often a 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 arguably manifest but also in ‘normal’ circumstances where ‘unknown unknowns’ are omnipresent.
In this context, Governor Bullock’s articulation of the optionality was noteworthy and wisely emphasised.
That is not to say that the Governor did not have a message. That message was that while ever the path back to the inflation target is of some significant distance, and while ever the labour market remains in a satisfactory enough state, the RBA will retain a (very soft) tightening bias.
The Governor quite sensibly laid out the fact that were the Bank to prematurely take ‘its eye off the inflation ball’, the potential macroeconomic dislocation that might eventuate would be more damaging than a scenario where the current stance of monetary policy remains unchanged.
That said, a downward adjustment in the policy rate sometime in 2024 remains eminently plausible, even if there is still some distance to travel before arriving at any imperative for a policy rate reduction.
The moderation in inflation in the December quarter reflects the impact of one-off subsidies such as for energy, childcare and rent assistance. As these effects wash out, and annual and administered price adjustments are reflected in the March quarter, there may be some stalling on disinflation progress.
Tuesday’s January monthly NAB Business Survey showed some pick-up in the rate of price growth as labour cost growth continued at elevated levels, albeit that those rates of growth are well down from those prevailing through 2023, but still well in excess pre-pandemic levels. That is a timely reminder that rather than being smooth, the process of disinflation tends to be more disjointed: a process of ‘two steps forward and one step back’ with the ‘last mile’ to the inflation target proving particularly challenging.
Developments in the US where the CPI has been “stickier” than expected reinforce that notion.
Fiscal developments too, including forthcoming tax cuts, and state government spending may make for “stickier” inflation. That is the case despite a structural case to be made for the tax cuts as articulated by the Government.
Perhaps of greater significance are productivity developments and their interplay with labour cost growth.
In her parliamentary testimony, the Governor cast herself as an “optimist” on productivity growth. However, at the same time she warned that unless productivity growth picked up, the journey back to the inflation target may involve an extended period before the RBA Board could meaningfully contemplate a cut in the policy rate.
While there was some tentative sign of an arresting of the productivity malaise in the September quarter national accounts, those same accounts revealed annual unit labour cost growth (the most relevant labour cost gauge for inflation) at around 6.5 per cent. In that context, it remains difficult to project any abatement of the “stickiness” in inflation for 2024 meaningfully beyond that projected by the RBA unless the economy slips into (near) recession.
Even if they’re the most recent, the September quarter measures are clearly dated. The December quarter accounts released on 6 March will be closely scrutinised by the Bank and the markets for indications of productivity trends and how they might feed into unit labour cost growth and therefore what they might imply for monetary policy.
The productivity challenge is given some poignancy by recent changes in the regulatory environment in Australia, particularly in relation to the wage-setting and the industrial relations framework. Even if well-intentioned, these changes potentially exacerbate an already stubborn inflation problem. They are broadly inimical to productivity growth, and they weaken the link between productivity and nominal wage growth, potentially entrenching higher inflation in Australia compared to elsewhere particular, even if economic activity weakens.
Of course, the RBA also has a mandate to be mindful of labour market conditions. Tomorrow’s issue of the January labour force numbers is therefore of some significance. There seems little doubt that the labour market is softening in the wake of tepid activity growth. However, Tuesday’s NAB Survey suggest that employment conditions, while softer, remain satisfactory. Were the unemployment rate to move quickly and significantly in excess of 4 per cent, such that the RBA forecast of 4.2 per cent at mid-year could be well exceeded, that might bring forward contemplation of a policy rate reduction. Despite tepid activity growth, that circumstance remains on one side of the risk continuum rather than a central scenario.
By Stephen Miller, investment strategist