Stephen Miller
The week just passed was meant to be one where markets obtained a clearer insight into when central banks, including the Federal Reserve (the Fed), the European Central Bank (ECB) and the Reserve Bank of Australia (RBA) might start cutting rates and how rapidly those various policy rates might decline.
In the event, the market’s information set was augmented, but only somewhat.
It now seems likely that the easing process will commence around mid-year with the ECB first cab off the rank in June or July, followed by the Fed in late July and the RBA in early August.
Central bank policy rate cuts from mid-year
In her press conference following last week’s ECB meeting, ECB President Christine Lagarde appeared to set the ground for a June policy rate cut, stating that while the ECB was “confident” regarding the return of inflation to close to target, they were “not sufficiently confident [to cut rates yet]”. She added that “we’ll know a little more in April, but a lot more in June.” Combined with the issuance of downwardly revised forecasts of inflation to close to the 2 per cent target, this seemed to imply some significant likelihood of a June or July rate cut.
Meanwhile, in congressional testimony Fed Chair Powell said the Fed was “not far” from having the confidence to cut the policy rate adding that such reductions “can and will begin” this year. Friday’s February non-farm payrolls report is unlikely to change that. While reported employment growth in February was strong there was substantial downward revisions to January and December while the unemployment rate jumped to 3.9 per cent from 3.7 per cent and average hourly earnings came in lower than anticipated at 4.3 per cent. Strong productivity growth in the US has kept unit labour cost growth to 2.5 per cent in 2023, and with continued productivity growth, decelerating wage growth implies a rate of unit labour cost growth consistent with the Fed’s inflation target.
In Australia, the December quarter national accounts release contained few surprises but emphasized the challenges facing policymakers. Growth remained tepid, in large measure reflecting very soft household spending. GDP growth per capita was negative for the third successive quarter but inflation indicators continued to exhibit worrying “stickiness”. This is a challenging environment for a RBA charged with a dual mandate on containing inflation and minimising unemployment.
“Sticky” inflation looms as the biggest hurdle to easing
Without doubt, the major uncertainty attaching to the sort of timing of central bank policy rate cuts outlined above remains the “stickiness” of inflation.
Rather than “immaculate” and 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, particularly in an environment (such as in the US) where economic activity is resilient. Even outside the US, where that resilience is largely absent, structural rigidities, particularly those attaching to the labour market, make for “last mile” challenges.
There are other key structural elements at work that will make that “last mile” even more daunting. The globalisation of labour supply (which began after the fall of the Berlin Wall – along with 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).
US February CPI report this week a key focus
In this context, this week’s release of the US CPI will be illuminating. A number close to the consensus for core CPI of a 12-month increase of 3.7 per cent implies that the challenge of “sticky” inflation remains. That would be consistent with a 3-month annualized increase of 3.9 per cent, unchanged from January and up from the trough of 2.6 per cent established back in August 2023.
Europe also faces a similar inflation challenge, although the weakness of the economy probably means that challenge is of a less order of magnitude.
RBA has to balance a dual mandate
Australian inflation has if anything surprised a little on the downside (certainly for this writer). Softer household spending may account for some of this but with the recent national accounts revealing that unit labour cost growth – the most relevant labour cost gauge for inflation – continuing to run close to 7 per cent in annual terms it would be wise for the RBA to avoid declaring victory just yet.
There are signs, however, that the inflation picture may improve at least in line with – and maybe ahead of – the current RBA projection. While elevated, unit labour cost growth has been declining on a quarter-by-quarter basis as productivity growth has bounced from the abject rates of growth in the first half of 2023. Were the soft economy to see the unemployment rate rise above the RBA projection of a 4.2 per cent average for the June quarter (which in my view seems likely) and were inflation to track at or below the RBA projection (plausible), perhaps reflecting the Governor’s “optimistic” productivity scenario, an August rate cut seems a reasonable central scenario. That would represent an appropriate balancing of the RBA’s dual mandate.
Fed and ECB rate cuts prior to August might buttress the case for a RBA cut as a means to prevent an undue appreciation in the AUD.
Inflation readings, however, remain critical and not just domestic readings. Too “sticky” an inflation rate globally as well as domestically may yet upset the emergent positive narrative on policy rate reductions in the second half of the year.
So no, we’re not there yet but we may be close!
By Stephen Miller, investment strategist.