RBA in limbo land; the Bank of Canada cuts because it can; the ECB has a similar plan; where does the Fed stand

Stephen Miller

RBA

At the margin yesterday’s March quarter GDP release supports the Reserve Bank of Australia’s (RBA) “wait and see” approach to any adjustment in the policy rate.

The report confirmed the widely held notion that activity growth is weak. In that sense it reaffirms the RBA fears that subdued output growth might at some stage be reflected in a deterioration in the labour market.

The accounts also go some way to alleviating concerns regarding productivity and unit labour cost growth, with the latter showing an annualised growth rate of just under 3 per cent in the six months to March.

The RBA Governor and Board have referenced negotiation of the “narrow path” between the successful and timely return of inflation to target while at the same time minimising any deterioration in the labour market.

The RBA Governor reiterated that in her Senate testimony yesterday.

In that context, the productivity and unit labour cost growth measures revealed by yesterday’s release will not dissuade the RBA’s from abandoning its current tolerance of a slower return of inflation so as to preserve as much of the labour market gains as possible.

That means there is little prospect of a change in the policy rate at the RBA Board meeting on 17-18 June and little prospect of a change in messaging from the “not ruling anything in or ruling anything out” mantra that the Governor has adopted.

Moreover, I think such messaging remains appropriate given the “narrowness” of the path.

Were, however, there to be a further upside surprise in the June quarter inflation numbers so that RBA’s (upwardly revised) trimmed-mean consumer price index (CPI) inflation forecast of 3.8 per cent is exceeded, then the 5-6  August RBA Board meeting may well have to consider increasing the policy rate further given the Board’s “limited tolerance for inflation returning to target later than 2026”.

My best guess – and it is just a guess – is that a further hike is unlikely given the likelihood that underlying weakness in activity growth will show through in a weaker labour market and allow a more confident projection of inflation declining toward target.

The most likely scenario is an extended pause in any policy rate adjustment until the RBA is convinced that its current trajectory for the return of inflation to target is secure. That argues for a policy rate cut toward the end of the year or sometime in the first half of 2025.

A sharper than anticipated slowdown resulting in a greater than anticipated dislocation in the labour market may bring the timing forward a little.

Policy in other areas hasn’t assisted the RBA in its inflation containment quest.

The Future Made in Australia (FMA) measures are a structural impediment to declining inflation.

Against the backdrop of changes to industrial relations and wage-setting arrangements, the FMA measures may inhibit the flexibility and dynamism of the economy.

That will limit potential long-term activity growth and see an accompanying increase in the non-accelerating inflation rate of unemployment (NAIRU), implying less favourable terms in the future for the trade-off between inflation and unemployment.

That will make it harder for the RBA to contain future inflation shocks without causing a larger increase in the unemployment rate.

At this point these are more “slow burn” type issues that are likely to be subsumed by cyclical developments, particularly if current tepid activity growth intensifies. However, their “unintended” negative consequences will grow in importance with the passage of time.

So, the circumstance as best one can discern it, and given the current information set, is that the RBA policy rate is probably not going up, but it may be some time before it can come down.

Bank of Canada and ECB

As was mostly expected, the Bank of Canada (BoC) cut the policy rate by 25 basis points to 4.75 per cent.

Moreover, and somewhat of a surprise, Bank of Canada Governor Tiff Macklem’s messaging that accompanied the BoC decision was on the dovish side saying that “if the economy continues to evolve broadly as we had expected, if we continue to see inflation pressures easing, it is reasonable to expect that there will be further cuts in interest rates.”

In so doing it reaffirmed a widely held view that developed country central banks are either actively engaged in or contemplating policy easing, and policy rate increases are likely in indefinite abeyance.

In all likelihood, the European Central Bank (ECB) will follow suit with cuts to its various policy rates when it meets this evening.

There are nuances attaching to the rate cut theme: the RBA (see above) has been less aggressive than the Canadians in raising the policy rate so will inevitably lag in following them down while the Federal Reserve (Fed) wrestles with a fiscal policy that frustrates its inflation containment objective, even when that fiscal policy is the product of an Inflation Reduction Act (an ironic moniker to say the least).

Canadian inflation has most recently printed on the low side of expectations. The Canadian trimmed-mean came in close to expectations at 2.9 per cent from 3.2 per cent in March while the median measure was slightly better at 2.6 per cent from 2.9 per cent in March. That has allowed the BoC some confidence in projecting a return of inflation to its 2 per cent target.

Governor Tiff Macklem said as much noting that “our confidence that inflation will continue to move closer to the 2 per cent target has increased over recent months.”

The relative inflation success may in part reflect that the BoC was relatively aggressive early and stayed more consistently on message regarding its inflation containment objective.

The ECB has not had the same consistency of messaging as the BoC, but persistent and pervasive (cyclical and structural) headwinds to activity growth have curtailed inflation sufficiently to allow them to cut the policy rates applying on the deposit facility, main refinancing operations and marginal lending facility by 25 bps from their current levels of 4.00 per cent; 4.50 per cent; and 4.75 per cent respectively,

In terms of future guidance, the ECB is also likely to be cautious despite recent comments from the French central bank Governor Francois Villeroy de Galhau that indicated an unwillingness to rule out a follow up cut in July, saying he wanted “maximum optionality”.

Other ECB Governing Council members have been more circumspect with regard to policy guidance beyond June.

Continued elevated wage growth has sometimes been cited as a concern that may lead to ongoing “stickiness” in services inflation.

That will probably sway ECB Governor Lagarde to refrain from overly exciting markets to anticipate any certain follow up in policy rate reductions at the July meeting even if she avoids ruling any such move out.

The Fed

US bond markets have exhibited a proclivity to welcome news that inflation has not been worse than expected.

But as Atlanta Fed President Bostic noted the modest improvement in inflation in April was “far from failing but not stellar.”

In that respect it may be instructive to note that markets have for some time proved way too optimistic regarding the rapidity of any decline in inflation.

It is in that context that all eyes are on Friday’s May non-farm payrolls report.

Fed Chair Powell has characterised the labour market as “normalising”.

As important as the payrolls data are, in the absence of a report a long way from expectations, it will be progress on inflation that will determine whether the Fed chooses to enact any policy rate cuts.

In this context, markets will likely be particularly exercised regarding the extent to which the May report reveals any tempering of wage pressure as well as focussing on conventional measures of employment growth and the unemployment rate. Decelerating wage growth would encourage a more positive narrative on inflation abatement and a more positive backdrop for financial markets and vice versa.

The consensus estimates for May non-farm payrolls are for an increase in employment of around 185k, an unchanged unemployment rate at 3.9 per cent, and for average hourly earnings to remain at 3.9 per cent annual growth.

The April Job Openings and Labour Turnover Survey (JOLTS) report released on Wednesday indicated some softening of the US labour market. US job openings fell to their lowest level in over three years. Fed Chair Powell has in the past had a particular focus on the ratio of job openings to unemployed people which is now at a three-year low of around 1.2. Powell has expressed a desire for the ratio to move towards 1. At its peak in 2022, the ratio was 2 to 1.

Also important was the employment component of the May Institute for Supply Management (ISM) Purchasing Managers Index (PMI) for services, released overnight. That component remained in contractionary territory. Although from a Fed perspective, the prices paid component remained stubbornly high and the overall index was surprisingly strong.

The ADP May payrolls report released overnight are consistent with an ongoing (but far from dramatic) softening of the labour market with employment growing by 152k (versus an expected 173k). While a reasonable enough indicator in and of itself, its record in foreshadowing month-to-month movements in the Bureau of Labor Statistics payrolls measure is at best mixed.

An outcome close to expectations for the aforementioned components of the non-farm payrolls report won’t move the dial for the Fed.

The real test comes next week with the release of the May US CPI on Wednesday next week at the same time the Fed is meeting.

While it is expected to stay on hold next week, it will issue a new Summary of Economic Projections including a new “dot plot” that will most likely indicate a median expectation of between one or two policy rate declines from the three projected back in March. The US bond market is pricing closer to two rate cuts

In that respect, and in somewhat of a contrast to where markets are heading, I remain of a sceptical bent rather in the vein of Atlanta Fed Chair Bostic.

Markets have seemed predisposed to regard modest progress on inflation as “stellar” and may be in line for somewhat of a reality check.

It will not surprise me if markets once again prove too eager in anticipating a policy rate reduction from the Fed given lingering “sticky” inflation.