Stephen Miller
Inflation good enough and labour market softening but ‘stagflation-lite’ environment still a key risk.
The US July consumer price index (CPI) report points to ongoing “stickiness” in inflation but absent any meaningful upward pressure from tariffs and given signs of labour market softening it is probably just good enough for the Federal Reserve (Fed) to cut the policy rate when it meets on 16-17 September.
Indeed, financial markets seem convinced with a September rate cut now priced at something close to a near certainty with an implied probability of around 85 per cent of a cumulative 75 basis point (bp) reduction in the policy rate before year-end.
My suspicion is that pricing reflects just as much the intense political pressure from the Trump Administration for cuts as it does the economic outlook.
Indeed, my key takeaway from the inflation report is that a ‘stagflation-lite’ environment remains a key risk.
Having said that it is not a risk that appears to be front of mind for equity markets and nor has it been since a brief swoon in the wake of President Trump’s ‘Liberation Day’ announcements back in April.
The more dire forecasts of macro-focussed analysts have not come to pass
At the time of those announcements many macro-focussed analysts foresaw a dire scenario. (Mea culpa – this writer was sympathetic to that view.)
In essence the received wisdom was that the tariff announcements would at least in the short-term make inflation “stickier” and that further, in order to quarantine that price impact from becoming embedded in inflation expectations and thereby become self-fulfilling, the Fed would need to adopt a conservative approach to reductions in the policy rate.
Additionally, a lax approach to the budget deficit that was already around 6.5 per cent of gross domestic product (GDP), would compound an already challenging bond issuance picture that would see bouts of market indigestion that would at the very least prevent bond yields from falling and perhaps send them higher.
An environment of relative monetary tightness, combined with some activity diminishing impact from tariffs and higher bond yields were thought to presage a ‘stagflation-lite’ type scenario with inflation stuck at three per cent or more and activity growth flirting with a recessionary environment. That was thought to be a particularly challenging environment for risk markets.
Even if some elements of that macroeconomic scenario have unfolded largely as anticipated, there is an important sense in which that macro-focussed analysis has proved awry.
Recovery in risk markets since early April has been impressive
The recovery in risk markets since the post ‘Liberation Day’ lows in mid-April have been impressive. The S&P 500 has bounced almost 30 per cent from its lows. To say that has come as a surprise to most macro-focussed analysts is a manifest understatement.
Why is that?
First, there is the ‘TACO’ (Trump Always Chickens Out) or ‘WACO’ (World Always Chickens Out) phenomenon. It is true that the Administration has walked back some of the more severe elements of the ‘Liberation Day’ announcements. That said, the baseline remains significantly worse than a no-chang’ scenario.
Second, the evidence in the hard data that the ‘stagflation-lite’ scenario is a clear and present danger is hardly overwhelming. Yes, inflation is “sticky” but is a long way from accelerating meaningfully and despite some labour market softness, economic activity has been more resilient. There is an argument that macro analysts have been ‘crying wolf’ on the economy and that the global economic circumstances are not as difficult as first thought.
Third – and probably most important – is that macro-focussed analysts understandably tend to give substantial weight to macro variables such as interest rates and bond yields, budget deficits, exchange rates, GDP growth etc., but often that leads them to underplay structural elements – the so-called ‘mega forces’ – that can be big drivers of equity market performance.
Mega forces associated with AI more important look to have been dominant…will that persist?
And there are some big structural – or mega force – themes at work at the moment: most notably the global transformation shaped by artificial intelligence (AI) and technology more broadly.
As BlackRock noted this week, big tech companies are boosting their AI investment even as tariffs threaten growth. The surge in tech and software spending in the US Q2 GDP – even larger than during the 1990s tech boom – highlights the AI theme’s growing macro impact.
These mega force influences can have profound effects on equity market performance.
As Nick Griffin from Munro Partners constantly reminds us: the equity market is not the macroeconomy.
So, should we just all relax a bit about an apparently expensive equity market?
Maybe. Or at the very least invest with the influence of those mega forces at front of mind.
But remember in that famous parable the wolf turns up in the end!
RBA in a good place…more cuts to come?
As was almost universally expected, the Reserve Bank of Australia (RBA) Monetary Policy Board announced at the conclusion of its August meeting a 25 basis point (bp) cut in the policy rate to 3.60 per cent.
The more interesting question is what might follow at subsequent RBA meetings in 2025.
Optionality retained but forecasts imply around a cumulative 50bps cut to the policy rate
On this the RBA Statement retained maximum optionality. As did the Governor at her follow-up press conference, although she did imply that the forecast maintenance of inflation near the middle of the target band and relative stability in labour market conditions imply around 50bps of cuts to the policy rate in this cycle.
Maintenance of that optionality is certainly a defensible approach given the uncertain outlook confronting the global and domestic economies.
Thus far, the RBA appears to have accomplished the navigation of the “narrow path” with more than a reasonable degree of competence, having guided inflation back toward target while maintaining the gains in the labour market.
For that it is to be commended.
Some risk of a further deterioration in the labour market
But while, the Governor may have retired the term “narrow path”, the task of balancing inflation at target while preserving gains in the labour market may still prove difficult.
Westpac estimates that the non-market sector (healthcare, education and public administration) has accounted for 95 per cent of the growth in hours worked in the economy over the past two-years and, further, if non-market job creation over this period had run at its pre-pandemic pace, the unemployment rate could be up to one percentage point higher.
To be fair, the RBA has always been sensitive to the risk that weakness in private demand may manifest itself in a weaker labour market, having been explicit about such a risk in recent Statements following Board meetings, including the Statement issued on 12 August.
With growth in public spending set to slow there will likely be an attendant slowdown in non-market sector employment. With private spending at best showing only tepid rates of growth it is doubtful that market sector employment is in a position to pick up any slack.
Complicating the picture is the fallout from the Trump tariff agenda.
While a dire scenario is not yet evident in any hard data, and indeed, assessments of the likelihood of such a scenario have been wound back, recent US labour data suggest that some diminution of global growth momentum must remain a key risk going forward.
The RBA Statement noted that 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, suggesting the RBA is alert to just such a risk.
RBA may need to more mindful of the labour market side of its mandate
That means the RBA may need to be more mindful of the labour market side of its mandate.
The “fly in the ointment” on inflation is continued sluggish productivity growth. That means unit labour cost growth – the most relevant labour cost gauge for inflation – is running around 5.5 per cent. On the surface, it is difficult to square that against inflation remaining close to the middle of the RBA’s two to three per cent target range.
The good news is that abject productivity growth has not prevented the gradual return of inflation toward the middle of the target two to three per cent band. The bad news is that it is an important element in extremely poor rates of growth in Australian living standards, both in absolute terms and relative to the rest of the developed world.
If inflation continues its moderating trend – and given unit labour cost growth, that remains a big “if” – then the RBA might find itself in a position to apply the requisite attention to the labour market.
Certainly, the RBA’s projection is for inflation to settle in the middle of the two to three per cent target band.
Worryingly, the NAB Business Survey for July recorded an uptick in both labour cost and goods price inflation.
That was matched by resilience in business conditions and employment.
And the June quarter wage price index was some way from worrying given forward projections of productivity growth (that may prove optimistic).
July labour force report looms
In that context, today’s release of the July labour force report loom as potentially important as will the August report which will be released before the next RBA meeting on 29-30 September.
Expectations for July centre on a circa 25k increase in employment after June’s disappointing 2k increase. The unemployment rate is expected to tick down to 4.2 per cent after a somewhat surprising increase in June to 4.3 per cent. That would be an acceptable outcome given still tepid activity growth and probably not one that would have the RBA scrambling toward the planning of a further decline in the policy rate in September.
However, as mentioned, the Governor seemed to indicate in her press conference, the RBA forecasts themselves assume that there are some further 50bps worth of decline in the policy rate in the period ahead, perhaps before the end of the year.
Should it emerge that the RBA has to pay increasing attention to the employment side of its mandate then it may be that there is more than 50bps worth of reduction in the policy rate in this cycle.
By Stephen Miller, investment strategist
