Stephen Miller
The March quarter gross domestic product (GDP) release certainly confirmed that the Australian economy remains mired in the doldrums. GDP growth remains tepid, at best, at just 0.2 per cent in the quarter and 1.3 per cent over the year. GDP per capita fell by 0.4 per cent over the year and indeed is still below the level three years ago.
Those sorts of growth numbers have seen the bond market’s expectation of a policy rate reduction when the Reserve Bank of Australia (RBA) Board next meets on 7-8 July at somewhere around 80 per cent.
Fair enough. I think the balance of probabilities are tilted toward the prospects of a policy rate reduction at that meeting, although I’m not as confident of that outcome as market pricing would have it.
At the conclusion of the last meeting, much was made of the RBA’s consideration of a “severe downside scenario”, noting that “monetary policy is well placed to respond decisively to international developments if they were to have material implications for activity and inflation in Australia.”
Such an observation left the door open to further policy rate reductions at future meetings, including the July one.
However, there was an element of conditionality that attached to any “decisive” response.
Presumably the RBA Board is anxious that the upending of the global trade system occasioned by the Trump Administration’s tariff agenda will constitute severe headwinds for the global economy in the period ahead.
Such anxiety is entirely reasonable but importantly, any evidence in the hard data is difficult to discern. It may well be just around the corner but has not, as yet, arrived.
In somewhat of a counterweight to the potential for a sharp deterioration stemming from international developments, the last RBA Board Statement canvassed some domestic developments that diminished the case for a larger cut.
It noted “a range of indicators that suggest that labour market conditions remain tight.” The April labour force report revealed a labour market in robust good health with the unemployment rate at 4.1 per cent, amid record high participation rates and surging employment growth.
The national accounts revealed wage growth around 3.8 per cent. Against continued sluggish productivity growth there are question-marks around the sustainability of current levels wage growth given unit labour cost growth (which remains elevated at 5.6 per cent), and the attendant negative inflation implications.
Inflation may yet reveal some residual “stickiness”.
The lack of attention in the recent election campaign to measures that might revitalise productivity growth was disappointing. Sluggish productivity growth means not only that the RBA’s inflation objective is harder to achieve in the near-term (absent a deceleration of wage growth) but importantly, over the longer-term, sluggish productivity growth is inimical to meaningful growth in living standards. That is one reason why GDP per capita is stagnant or declining.
Remember the March quarter consumer price index (CPI) report was just good enough, with trimmed-mean inflation at 2.9 per cent, for a cut in May. Although the RBA forecasts now have underlying inflation expected to be around the midpoint of the two to three per cent range until at least mid-2027.
Sluggish productivity growth and its persistence is the “wart” that attaches to the bond market’s confidence in a policy rate cut in July.
Despite persistent productivity complications, it seems clear that the RBA Board sees the most worrying risk in the near-term as a sharper deterioration in global growth and the consequences of that deterioration for a medium-sized open economy such as Australia’s.
That is the case despite the President walking back some elements of the “Liberation Day” announcements. That walking back only mitigates the potential damage relative to the baseline of no change. It does not eradicate the damage. In that context, in my assessment, a global recession in the next year or so remains a reasonable prospect.
In other words, the RBA may yet institute successive policy rate reductions at future RBA Board meetings, but it is at this juncture a far from a certain outcome.
Nevertheless, Australia’s eschewal of retaliatory tariff measures has given the RBA a less complicated path to attacking the any adverse consequences of a global trade war. This was perhaps the message around the ability to “respond decisively”.
The absence of retaliatory measures will mean a mitigation domestically of the inflation part of the global “stagflation-lite” scenario, allowing the RBA to cut rates and, if need be, to cut aggressively to forestall a sharp decline in economic growth, the productivity “wart” notwithstanding.
Coming up: US May non-farm payrolls. Next week will see US May CPI. Is the “hard rain gonna fall”?
The Fed has signalled a degree of circumspection with respect to future policy rate reductions.
The current (March minted) “dot plot” implies just two 25 basis point (bp) cuts this year.
And not much in the way of Federal Reserve’s (Fed) communication has changed that picture.
Markets too seem pretty accepting of such a scenario as the central case.
That reflects, inter alia, persistent anxieties around a “stickier” inflation picture.
At the forefront of those anxieties is the potential inflationary consequences of the Trump trade agenda.
The “big beautiful bill” that contains tax cuts that are not matched by expenditure reductions will likely fuel inflation. (By adding to an already gargantuan budget deficit it will also keep bond yields higher creating headwinds to growth).
There has also been much commentary around whether the Trump agenda leads to a recession, or a ‘stagflation-lite’ scenario. The latter sees CPI inflation stuck at three plus per cent while activity growth flirts with recession.
While that ‘stagflation-lite’ scenario is not without logic, there has been little by way of hard data to support it.
The upcoming May data will be closely scrutinised for evidence of either recession and/or ‘stagflation-lite’ portents. Key data points will be Friday’s May payrolls report and next Wednesday’s May CPI release.
The consensus estimate for May non-farm payrolls is for an increase in employment of around 130k and an unchanged unemployment rate at 4.2 per cent. Wages growth, as measured by average hourly earnings, are expected to grow by 3.7 per cent, a little below April’s 3.8 per cent.
The April Job Openings and Labour Turnover Survey (JOLTS) report released on Tuesday were stronger than expected, albeit not inconsistent with some moderate easing of labour market conditions.
The ADP May payrolls report released overnight showed employment slowing growing by only 37k (versus 114k expected) and follows a modest 60k increase the previous month. 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.
The employment component of the Institute of Supply Management (ISM) manufacturing and non-manufacturing purchasing managers indices (PMI) paint a mixed picture. Manufacturing employment is weak, although non-manufacturing employment released overnight remains resilient. More worrying is that the price components of both of those indices indicate a potential acceleration of inflation.
An outcome close to expectations for the aforementioned components of the non-farm payrolls report won’t move the dial for the Fed.
And I think that currently that dial is on “I think we’ll stay put” position on a rate cut for the scheduled 17-18 June meeting.
Whether that dial moves might be somewhat dependent on next week’s CPI.
The March and April CPIs were better than feared but were judged as being too soon to reveal any price pressure emanating from tariffs.
Bank of Canada (BoC) holds steady
As expected, the Bank of Canada (BoC) held the policy rate steady when it met overnight. The decision to hold the policy rate steady at 2.75 per cent follows a pause in the rate-cutting cycle in April after seven cuts in a row, as a 2.25 per cent reduction in the policy rate over the preceding nine months reflected a weak labour market (Canada’s unemployment rate is at 6.9 per cent) and declining inflation.
While April core CPI inflation in Canada came in at 2.5 per cent which is within the BoC’s target range of one to three per cent, the key median and trimmed-mean measures were at 3.2 per cent and 3.1 per cent respectively, both well in excess of expectations.
In a Statement accompanying the decision, the Bank noted that “with uncertainty about US tariffs still high, the Canadian economy softer but not sharply weaker, and some unexpected firmness in recent inflation data, governing council decided to hold the policy rate as we gain more information on US trade policy and its impacts.”
There are serious challenges ahead for Canada, as a consequence of the Trump tariff agenda. Should the Canadian government choose retaliation, that would raise the spectre of a “stagflation-lite’ scenario as prices rise more rapidly (at least in the near-term) while activity growth languishes. The challenge for the BoC in the first instance is to keep inflation expectations anchored even with activity facing potentially severe headwinds. Newly minted Prime Minister has held fire on at least some retaliation measures despite earlier indicating he would go aggressively down that path. An easing of retaliation measures would give the BoC greater degrees of freedom in mitigating the activity fallout from US tariffs.
While noting a “diversity” of views on the future rate path, BoC Governor Tiff Macklem stated that “on balance, members thought there could be a need for a reduction in the policy rate if the economy weakens in the face of continued US tariffs and uncertainty, and cost pressures on inflation are contained.”
ECB: here we go again
The European Central Bank (ECB) is almost certain to cut its key deposit facility rate by 25bps to two per cent when it meets this evening (AEST). That would mark the eighth cut of this easing cycle and the seventh back-to-back reduction.
That decision would come in the wake of another benign CPI outcome as May Eurozone core inflation came in as expected at 2.4 per cent (on a harmonised basis). Conventional headline and core CPIs came in at 1.9 per cent and 2.3 per cent respectively. Europe’s strong disinflationary trend reflects an extended period of weak economic activity.
Markets have fully priced the move.
There is some interest on the guidance going forward. I would expect ECB President, Christine Lagarde, to give herself and the ECB Council maximum optionality going forward. Inflation is certainly benign but any aggressive retaliatory action from the European Union to the Trump tariff agenda complicates the picture.
By Stephen Miller, investment strategist
