It takes an unlikely Melbourne Cup Day trifecta to see a RBA policy rate reduction

Wednesday’s monthly consumer price index (CPI) indicator report added little to the market’s available information set in terms of their expectation regarding the next (almost certainly downward) adjustment in the Reserve Bank of Australia’s (RBA) policy rate.

Favourable base effects relating to electricity prices, including subsidies that took effect from July, saw the headline inflation rate decline to an annual 3.5 per cent. That decline, however, was less than expected. Moreover, domestic (non-tradable) inflation and services inflation remain uncomfortably “sticky” at 4.5 per cent and 4.4 per cent respectively (the former despite those aforementioned favourable subsidy effects).

RBA Governor Michele Bullock cast a hawkish hue over the most recent RBA Board decision to leave the policy rate unchanged at 4.35 per cent at its August meeting. In particular, her affirmation that the Board considered a policy rate rise (but not a cut) combined with an assessment that any near-term reduction in the policy rate was unlikely had led the market commentariat thinking (rightly in my view) that any reduction would need to wait until 2025.

Market pricing has been more optimistic with current pricing implying a full 25 basis point (bp) cut by year-end.

The last couple of years have seen market pricing of central bank policy rate reductions (both in Australia and elsewhere) prove to be way too optimistic. I think that is the current case that attaches to the RBA and Australian market pricing, albeit in a less egregious fashion than witnessed say in the year and a half leading up to early 2024.

Arguably the best that one can say with regard to the July monthly CPI indicator is that inflation is on a downward path but thus far it is a grudgingly slow process.

And unless there is some wholly unanticipated and at this stage unlikely deceleration in inflation that is at a pace greater than revealed by the most recently issued RBA forecasts, any RBA policy rate reduction this year is a remote prospect.

The RBA’s inflation containment task continues to be frustrated by counter-productive government policies despite some tortured political commentary that denies that circumstance.

In the Australian context the arrangements attaching to wage-setting and industrial relations regulation have complicated the RBA task by making inflation “stickier” and increasing the non-accelerating inflation rate of unemployment or NAIRU.

The Future Made in Australia measures may well have a similar effect.

Fiscal policy in Australia, mostly (but not exclusively) at the state government level has not helped.

Government spending would increase aggregate demand by a chunky couple of percentage points of gross domestic product (GDP) in 2024-25, thanks largely to big-spending state governments erroneously purporting to provide cost-of-living “relief”.

With excess demand a primary driver of inflation, that government contribution is problematic, at least those elements that don’t have attenuating and near-term supply-side effects (which arguably the income tax cuts do).

What they do, however, is give the RBA some ability to exercise patience in contemplating any downward adjustment to the policy rate.

An unkinder interpretation is that fiscal laxity has exacerbated inflation pressures and led to a delay of interest rate relief.

Therefore, while there is a plausible (if at this stage improbable) set of circumstances that see a rate cut in 2024, my judgement is to line up behind the assessment of the RBA Governor and Board that any near-term policy rate reduction is unlikely. My sense remains that February 2025 remains the most likely time for the first reduction in the policy rate from its current level, but it could be as late as May 2025.

The improbable circumstance of a rate reduction this year would seem to hinge on a rapid deterioration in the labour market.

The Board noted in its Statement following the August meeting that ‘momentum in economic activity has been weak…[a]nd there is a risk that household consumption picks up more slowly than expected, resulting in continued subdued output growth and a noticeable deterioration in the labour market.’

Were the monthly labour force releases between now and the meeting in November to reveal a ‘noticeable deterioration in the labour market’ significantly beyond that currently forecast by the RBA, then a November policy rate cut may emerge as a reasonable prospect, particularly if the September quarter CPI print is in line with (or better than) the recently issued RBA forecast.

That notion may be fuelled should the Federal Reserve (Fed) cut its policy rate by 50bps when it meets in September (something I regard as unlikely) and the Australian dollar (AUD) appreciates sharply leading to a tightening of financial conditions.

The RBA has a dual mandate that relates to minimizing unemployment as well as inflation containment. My sense is that the Governor and the Board take that duality extremely seriously.

However, in the absence of an unlikely trifecta of “acceptable” inflation outcomes (in line with RBA forecasts or better), a rapid and excessive dislocation in the labour market, and an aggressive Fed policy rate cut that results in a sharp appreciation of the AUD, a Melbourne Cup Day policy rate cut remains a long shot.

Aside: RBA Deputy Governor Hauser seems to have copped a fair amount of criticism for his recent Beware of False Prophets address. Perhaps someone should have warned the Deputy Governor of the Australian “tall poppy syndrome” penchant.

Some might attribute that national characteristic to the country’s longstanding egalitarian tradition (if indeed that does exist). Others might put it down to a collective national insecurity about their own place in the world and its importance (or lack thereof).

Whatever it is, I think the criticism of Hauser was off the mark. My view is that most commentators missed the fundamental point he was making. As AFR economics editor, John Kehoe wrote, this was that central banks need to understand the huge limitations on their knowledge of the economy and more than that be open about those limitations and make sure markets understand them.

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 and (as I’m sure former RBA Governor Philip Lowe would argue) an ignorance of any conditionality that attaches to central bank commentary and guidance. (In saying that I’m not excusing Lowe’s now (in)famous guidance regarding the timing of policy rate rises. He himself should have given way more emphasis on the conditionality around that guidance.)

To invoke that famous central banking philosopher, former US Defence Secretary Donald Rumsfeld, there are ‘known unknowns’ (particularly manifest in the post-pandemic period) and omnipresent ‘unknown unknowns’.

RBA Governor Bullock has been clear on this as exemplified by the ‘not ruling anything in or out’ mantra attaching to likely future moves in the policy rate.

Hauser’s speech was an attempt to make this clear and so avoid the sort of imbroglio that followed Lowe’s now (in)famous guidance.

Powell at Jackson Hole: the time has come the Walrus said…

US Fed Chair Powell’s address at the Kansas City Fed’s Jackson Hole Symposium confirmed one of the Fed’s worst kept secrets: that the Fed will cut the policy rate at its September 17-18 FOMC meeting.

Powell’s language was unequivocal, asserting ‘the time has come for policy to adjust’.

Powell’s address implied (not without reason) that it is “mission accomplished” on inflation and that the Fed is focused on the other element of their dual mandate; viz, minimising any deviation from full employment. Powell stated that the Fed does ‘not seek or welcome further labour market cooling’ and that the Fed would ‘do everything we can to support a strong labour market.’

The only debate seems to be whether the Fed chooses to kick-off with a 25 basis point (bp) policy rate cut or a 50 bp cut.

The arguments for the higher quantum of cut are that to all intents and purposes the Fed has achieved its inflation objectives. Measures of the inflation “pulse” show the Fed has achieved (or bettered) its 2 per cent target.

The Fed’s favoured core personal consumption expenditures (PCE) measure was running at a 3-month annualised pace of 2.3 per cent in June. It is likely to come in around (or even a tad lower) than 2.0 per cent when the July numbers are released on Friday.

The July non-farm payrolls report appeared to show a rapidly cooling labour market so much so that some of the market commentariat thought them a harbinger of an imminent recession.

With the inflation “pulse” at less than 2 per cent and with the labour market (according to some) flashing recession signals, and with policy described by Fed Chair Powell as being in “restrictive” territory, the way is certainly open for the Fed to cut 50bps. But it will probably need the August payrolls data released on 6 September to show a continuation of the weakness evident in the July report to elicit such a cut.

Leaving aside the market tendency over the last few years to “cry wolf” on recession, there are reasons to think that the July figures overstated the extent of weakness in the labour market (associated with temporary lay-offs depressing the employment count, a surge of new labour force entrants increasing unemployment and the absence of any dramatic weakening – as opposed to orderly “cooling” – evident in other labour indicators). On that basis one would expect some bounceback when the August report is released on 6 September. Were such a bounceback to eventuate, the Fed might seek to implement a 25bp cut in September and express a disposition, contingent on the data, to follow-up with similar cuts in November and December.

At this point, and not with a great level of conviction, I think the (latter) more cautious approach more likely.

At his press conference following the last meeting (but before the July payrolls release) Powell stated that a 50 bp cut was “not something we’re thinking about right now.” If, as I tentatively expect, the August payrolls do show some bounceback, I think that will be sufficient for him to stay with that script.

By Stephen Miller, investment strategist