Stephen Miller
RBA: monetary policy bias swinging to neutral, but still some distance to any imperative for a policy rate cut
Yesterday’s release of the January Monthly consumer price index (CPI) indicator contained some signal amongst the noise.
It certainly wouldn’t have come as bad news for a Reserve Bank of Australia (RBA) Board hopeful that it had done enough to see inflation return to target within the forecast period.
And to the extent that the Reserve Bank of New Zealand (RBNZ) enunciated a less hawkish than expected commentary around its decision to keep the policy rate on hold, that might provide some encouragement for the RBA, although I doubt that the RBNZ decision would influence in any material way RBA Board deliberations.
But getting back to yesterday’s Monthly CPI indicator release, while it was at the lower end of expectations and further, while it is consistent with the RBA February forecast track, it contained little by way of coverage of developments in service price inflation, particularly the critical domestic component of service price inflation. It is likely to be from that source that any upside challenge to the RBA forecast would emerge. It also reflected the impact of temporary one-off subsidies such as government electricity rebates which will unwind in the future.
As such, the data cannot be expected to shift the dial toward any meaningful adjustment to the RBA stance at the forthcoming 18 – 19 March RBA Board meeting.
Perhaps the only meaningful data point since the RBA last met was the January labour force release which painted a picture of a softening labour market – perhaps a labour market that was softening at a pace greater than the RBA might have expected. That said, shifting seasonal patterns in the labour market made interpretation of that particular release difficult. Perhaps a little frustrating for the Bank is that the February labour force release, which might be expected to provide a clearer prism through which to make judgements about the extent of softening in the labour market, is not released until 21 March – two days after the conclusion of the next RBA Board meeting.
The December retail sales report was also very weak, again one suspects because of shifting seasonal patterns. The January report released today will be closely watched for the highly anticipated bounce back from December’s weakness.
The forgoing data caveats notwithstanding, the picture that appears to be emerging is of an economy that may be growing at a more tepid pace than the already soft RBA growth trajectory and where inflation is declining at a rate that is certainly consistent with, and maybe even ahead of, of the RBA forecast.
That almost certainly means that the next move in the policy rate is a downwards one.
At her inaugural post-Board meeting press conference and in her later parliamentary testimony, RBA Governor Michele Bullock, articulated a well-framed and appropriately nuanced message which (quite properly) gives the Board maximum optionality going forward.
In this context, Governor Bullock’s articulation of the optionality was noteworthy and wisely emphasised. The data releases since that time have only served to emphasise this point.
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 – probably likely – even if there is still some distance to any imperative for a policy rate reduction.
The 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. 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 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.
The RBA Governor has 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 1/2 per cent. In that context, it remains difficult to confidently 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 are to be released on 6 March. Not only will they be closely scrutinised in terms of the economic activity picture but also for indications of productivity trends and how those trends might feed into unit labour cost growth.
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.
It is for the time being difficult for the RBA to meaningfully adjust the message from the February meeting where it appeared to possess a (very soft) tightening bias.
But my sense is that bias is swinging toward neutral. A move to an easing bias that might presage a policy rate cut is still some time away.
Were there to be worryingly weak activity data from the national accounts issued on 6 March, combined with a better productivity / unit labour cost picture, and were the February labour force data to confirm an ongoing and significant softening of the labour market such that the RBA unemployment rate forecast of 4.2 per cent at mid-year could be significantly exceeded, and finally were the March quarter CPI figures (released on 27 April) to reveal that inflation is declining at a rate consistent (or better than) the current RBA forecast then that might bring forward an easing bias in May and an attendant serious contemplation of a policy rate reduction to somewhere around mid-year or just beyond.
The consensus view of the US economy is one that is commonly described as “goldilocks”: a resilient economy in which inflation declines to an extent that the Federal Reserve (Fed) can make some cuts to the policy rate, even if the magnitude of those cuts has been pared back markedly over the last month or so – partially reflecting the resilience of US activity indicators. This is an “immaculate disinflation” scenario in which bond yields are at least stable or falling and equity markets are pushed along by tailwinds associated with stable or falling bond yields and continuing economic growth.
To be fair that “goldilocks” scenario is a deserved central case even if one accepts that the US equity market looks expensive when compared with traditional valuation metrics. As my good friend, Gerard Minack, points out in one of his always thoughtful commentaries, many traditional bubble features – rising leverage, a dash to trash, rising equity issuance and nosebleed valuations – are missing from the current market. So it’s possible that expensive valuations persist before any substantial downdraft presents.
But arguably there are some indications that the bears are gaining on a tiring “goldilocks”.
The next day or two sees some critical data points including the January (core) private consumption expenditures price index (PCE) – the Fed’s favoured inflation indicator – and the February Institute of Supply Management (ISM) manufacturing index. The core PCE index will certainly show an acceleration in the monthly rate of inflation and in the 3-month annualised ‘pulse’ measure, the latter increasing to 2.6 per cent in January from 1.5 per cent in December. That may underscore existing concerns regarding the “stickiness” of inflation and whether bond yields may in fact still have some upside risk.
The global economy is also confronted by a myriad of different potential risks. For one thing, developed market (DM) growth outside the US is languid. Moreover, as Gerard notes, the bull run in the US equity market is narrowly driven – the so-called “magnificent seven” (M7) have more than doubled since the start of 2023 – although this was partly payback for the preceding bear market (the Bloomberg BM7P index halved through 2022). And in the US and elsewhere the goldilocks scenario faces significant challenges: whether on the macro front (“sticky” inflation and / or recession versus “goldilocks”), or on the structural side (a higher “neutral” interest rate, emboldened regulators, growing protectionism, supply chain security, and emergent “mega forces” such as decarbonisation and AI).
Geo-political risk is elevated from US Presidential elections (and elections elsewhere), the Russia / Ukraine conflict, the Middle-East, China / Taiwan, the Korean Peninsula, growing cyber security challenges to name just a few.
At the very least, the “goldilocks” consensus is insufficiently nuanced.
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 where economic activity is resilient. As mentioned, tonight’s January core PCE will only emphasise that.
There are key structural elements at work that will make that “last mile” to the inflation target potentially more daunting.
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.
An alternate viewpoint to recession risk. For example, last year’s unexpected resilience might have been the result of a US fiscal “sugar hit” as the budget deficit approached an unprecedented 7 per cent of GDP, even as the economy hovered around full employment. In the almost certain event of a withdrawal of that fiscal support the ongoing impact of the monetary tightening in 2022 and 2023 might need to be withdrawn resulting in aggressive policy rate cuts.
A recession might mean sharp cyclical downside in earnings and episodic equity market wobbles.
The forgoing implies at the very least episodic bouts of volatility where investor conviction comes under strain, engendering potentially seismic shifts in investor sentiment and similarly seismic shifts in the prices of financial assets.
Such an environment increases the potential for return from skilled active managers. Higher volatility typically leads to greater dispersion of returns of individual issuers of bonds or equities. The “mega forces” of climate and artificial intelligence are likely to accentuate that but so are more mundane elements (housing shortages, strains on health systems from aging populations etc.).
More importantly, the forgoing underscores perhaps the most important and over-arching principle of investing: diversification. That doesn’t just mean via security selection within a particular asset class or sector but also diversification away from both bond and equity beta within multi-asset portfolios – for example, long / short liquid alternatives, macro / quant hedge funds, gold, or maybe even, for the adventurous, very small crypto exposures.
These observations retain some poignancy in the current environment.
Even if Goldilocks is ahead the bears may be gaining!
By Stephen Miller, investment strategist