RBA: the narrow path resembles a tightrope; a “verbal pivot” in the offing? The Fed: Déjà vu all over again?!

Stephen Miller

The Fed: Déjà vu all over again?!

Yogi Berra was a US baseball coach renowned for his mangling of expression. He is most famous for coining the phrase “déjà vu all over again”.

However, rather than a mangling of English, that expression perhaps encapsulates the US bond market’s repeated disappointment with the “stickiness” of inflation.

At the start of the year the bond market was anticipating something close to 175 basis points (bps) of policy rate cuts or seven different episodes of 25 bp cuts. To put that in perspective, that would have required a rate cut at every meeting following the Federal Reserve (Fed) meeting concluding on 31 January. That view took hold despite the Fed’s median “dot plot”, issued after the meeting concluding on 13 December, implying only 75 bps of policy rate cuts or three 25 bp reductions for 2024.

Markets are now reasonably closely aligned with the Fed view expressed back in December. In some sense that may account for the equanimity with which financial markets greeted another higher than anticipated inflation number for February. Arguably, complacency might be a better descriptor.

What markets may be less aligned with is the potential for the Fed’s view to evolve into something that implies an even more cautious approach to policy rate reductions.

After Tuesday’s release of the February consumer price index (CPI), and Thursday’s producer price index (PPI) release it will certainly be difficult for the Fed at next week’s Federal Open Markets Committee (FOMC) meeting to accelerate the policy rate projection issued back in December and it is not implausible that it may be wound back a little.

Measures of the “inflation pulse” indicate some ongoing and troublesome “stickiness” in inflation.

The 3-month annualised core CPI was 4.2 per cent in February, a stark deterioration from a trough of 2.6 per cent in August 2023, and was the highest since May last year. The 3-month annualised Cleveland Fed trimmed-mean measure rose to 4.4 per cent in February from a trough of 2.8 per cent in July 2023, and was the highest since March last year – meaning there has been little progress in this measure for almost a year. The 3-month annualised Cleveland Fed median measure remained elevated at 5.1 per cent, an improvement on the 5.3 per in January, but that was the highest since April 2023.

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”) remained at 6.4 per cent, the highest since February 2023. The admittedly volatile services less rent-of-shelter measure rose to 6.9 per cent, the highest in 18 months.

Arguably, these trends are more than indications of “stickiness”. Rather they border on indications of a reversing of the disinflation trend that appeared to emerge from around the middle of the year.

Such indications will reinforce the current tendency of Fed officials to be (properly) reticent of declaring “mission accomplished” on inflation.

That reticence may turn to more overt resistance if the trends in the February 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 until December but showed signs of reversal in January. The 3-month annualised rate of growth in that measure was at an admittedly acceptable enough 2.6 per cent in January but the February CPI and PPI report indicate a clear risk – even likelihood – of a re-acceleration of that measure. That measure could rise significantly to around 3.25 per cent or higher in February. That would take this measure to its the highest level since May 2023. Such an outcome will inevitably lead to some questioning of the Fed’s ability (perhaps including among FOMC members themselves) to get to its December core PCE projection for 2024 of 2.4 per cent.

The February CPI and PPI reports were a reminder that the process of disinflation tends to be 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 (skilled) 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).

All that leads me to expect some cautious messaging from the Fed when it meets next week. Despite a meaningful paring of what appears to have been egregiously ebullient rate cut expectations at the beginning of the year markets may still yet be disappointed with what comes of that meeting and the associated update Fed projections and “dot plot”.

Bond markets are mostly prepared for such messaging. I’m not sure the same is true of equity markets.

A case of déjà vu all over again?!

RBA: the narrow path resembles a tightrope; a “verbal pivot” in the offing?

Given the apparent resilience of the US economy, there doesn’t appear to be a substantial risk of activity blowback if the Fed were to temper market expectations of a policy rate reduction in the wake of higher than anticipated inflation, at least in the short-term.

The circumstance facing the Reserve Bank of Australia (RBA) as it prepares for a Board Meeting next week are a little more challenging. Inflation is declining but is still some way north of the target even as economic activity languishes. For a RBA charged with a dual mandate on containing inflation and minimising unemployment, balancing those risks is a tricky undertaking. Indeed, it makes the previous Governor’s “narrow path” resemble a tightrope.

It is the case that Australian inflation has if anything surprised a little on the downside (certainly for this writer). That may well reflect softer household spending and a concomitant softening of the labour market.

However, as has been the case in the US and elsewhere, the “last mile” in getting inflation back to target is an especially daunting task.

The recent September quarter national accounts indicate that unit labour cost growth – the most relevant labour cost gauge for inflation – continues to run close to 7 per cent in annual terms.

Tuesday’s NAB Monthly Business Survey for February showed a clear acceleration of price pressures since the December low. While not back at levels seen in the first part of 2023, that survey suggests that the modest downside surprises in inflation may well be reversed in coming months.

Some of the downside surprise in inflation reflected the impact of temporary one-off subsidies such as government electricity rebates which will unwind in the future.

Fiscal developments too, including forthcoming tax cuts, and state government spending may make for “stickier” inflation. (Even if there are offsetting supply-side effects from the tax cuts that after all just hand back bracket creep.)

Nevertheless, a reasonable central case has the inflation picture improving more-or-less in line with 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 the RBA projection (plausible), perhaps reflecting the Governor’s “optimistic” productivity scenario, a rate cut some time in the second half of the year seems a reasonable central scenario.

That would be consistent with a balancing of the RBA’s dual mandate.

In this context the RBA Board and Governor might at next week’s Board meeting avail themselves of a subtly expressed “verbal pivot” by going to a neutral bias from what was a (very soft) tightening bias at the last meeting.

Were that to occur, I’d expect the Governor to do so by emphasising that the next move in the policy rate could still be an upwards one and there being only a grudging admission that a downwards move is implicitly just as likely.

Inflation readings remain critical and in my view the RBA would like to see both the March and June quarter CPI data before deciding on a rate cut.

However, too “sticky” an inflation rate could still upset any emergent positive narrative on policy rate reductions.

By Stephen Miller, investment strategist