Stephen Miller

USD: the “cleanest dirty shirt”. It wasn’t that long ago that “dollar debasement” was flavour of the month.

• An adversarial stance on trade and geopolitics was thought to lead to a diminution of investment flows into the US
• Central banks were thought to wish to diversify away from USD
• The Fed at the start of 2026 was thought to be in easing mode and there were concerns regarding its independence
• The Administration revealed an antipathy to the notion of “exorbitant privilege”.

• Huge investment flows into the US equity and corporate bond markets associated with massive AI related capex have replaced negative views around trade related and geopolitical withdrawal from the USD.
• European turmoil. Europe’s status as a safe haven has diminished.
• The Fed is on a tightening tack
• Oil prices increase the attraction of the USD now that the US is a net petroleum exporter
• Gold is recovering from 2025’s speculative excess.

Ebullient equity market meets anxious bond market

The headlines in the financial press are replete with anxiety over such “high” bond yields. Ordinarily, such a surge in bond yields would presage anxiety in equity markets.

Yet the US equity market (measured by the S&P500 index) has powered to record highs as recently as Tuesday and it remains just shy of there. What gives?

• Large parts of the equity market are languishing.
• The boom is “narrow” (AI and tech related). These are not troubled by higher bond yields (yet!). A big structural shift has seen massive capex validated by muscular earnings growth.
• May yet have a way to go (although there will inevitably be setbacks).
• Investors should be wary of the challenges around higher bond yields.
• But strong outperformance in particular sectors (AI and tech) can overwhelm underperformers and drive equity markets (particularly the US) higher despite the challenges posed by higher bond yields.

The US Dollar: the “cleanest dirty shirt”

Johnny Cash had a hit with Kris Kristoffersen song Sunday Morning Comin’ Down. In that song, the protagonist laments that:

…the beer I had for breakfast wasn’t bad
So I had one more for dessert
Then I fumbled through my closet for my clothes
And found my cleanest dirty shirt…”

Maybe the “cleanest dirty shirt” is an apt analogy for the US Dollar. One of the more surprising developments this calendar year has been the strength of the USD.

It didn’t seem that long ago when “dollar debasement’ was flavour of the month. It appeared that there was some sort of consensus among the financial market punditry that the USD was poised for a period of long-term decline. (This pundit was sympathetic to that viewpoint.)In essence that reflected some uncertainty over the durability of the USD as a safe-haven destination, which in turn reflected a number of factors, including:

• An increasingly adversarial approach to trade and geopolitics that was thought to diminish the attractiveness of the US as a destination for investment flows;
• Diversification away from the USD and US government bonds as a source of foreign currency reserves by central banks and sovereign wealth funds;
• An antipathy on the part of the members of the Trump Administration to the notion of “exorbitant privilege” (which manifest itself in an overt desire for depreciation of the USD); and;
• A view that the Fed was likely to cut the policy rate and fears over the independence of the US Federal Reserve.

And alternatives to the USD are limited.

For one thing, gold prices had by early 2026 begun to behave in a manner that suggested excessive speculative flows. Perhaps the most notable twist on the negative USD scenario is that there are demonstrable offsets to the aforementioned investment flow concerns.

These offsets have largely taken the form of flows into the US equity and corporate bond markets associated with massive AI related capex.

In some measure that reflects a relatively more welcoming US regulatory environment for capital in the US than Europe (and Australia for that matter).

Strong capex is reflected in robust US productivity growth. The rest of the developed world is languishing.

It is also clear that other developments have soured the attractiveness of alternatives, particularly in Europe where the rise of extreme right and left political groupings have created an environment of political and economic uncertainty.
Those developments come on top of an overly complex regulatory regime which is not an encouraging environment for investment. (As Peter Swan pointed out in an article in the Australian Financial Review that argument might be made for Australia too).

The forgoing European difficulties have occurred against a background of continuing resilience of the US economy even in the wake of higher oil prices and higher bond yields. US economic resilience is in no small part reflective of that massive AI capex referred to earlier. This has coincided with some diminution in concerns regarding Fed independence in the wake of a September Fed policy rate increase, all of which has led to USD strength.

In saying that, I’m not suggesting that policy in the US is perfect. Far from it (think budget deficits, tariffs, erratic policy pronouncements etc.) but more that the USD is the “cleanest dirty shirt”, certainly compared to the Euro and (at least for the time being) gold.

Also of some importance is the rapid run up in oil prices in the wake of the Iran conflict. At the margin that has increased the attraction of the USD given that the US has been a net petroleum exporter since 2011. Prior to 2011 higher oil prices constituted a negative terms-of-trade shock. In the period since it is the opposite. Higher oil prices enhance growth in economic activity and increase the attraction of the USD.

But it is the allure of US as a destination for risk capital (in the form of equity and corporate bonds) that is currently the dominant theme. Same may see AI as a bubble waiting to burst, in which case the USD “dirty shirt” quickly returns to the closet.

Others see it as not a bubble but a boom. If the latter, the “dirty shirt” might get even cleaner.

Ebullient equity market meets anxious bond market

The US 10-year bond yield has surged upwards, reaching levels not seen since 2002 and is over 100 basis points higher than at the commencement of the year.

The headlines in the financial press are replete with anxiety over such “high” bond yields.

Ordinarily, such a surge in bond yields would presage anxiety in equity markets.

Yet the US equity market (measured by the S&P500 index) has powered to record highs as recently as Tuesday and it remains just shy of there.

What gives?

Well for one thing large parts of the equity market are not at record highs. The dispersion in stock performance has been historically high. The “leadership”, in terms of performance of particular stocks, is quite narrow.

Resilient economic activity reflects massive capital expenditure associated with the increasing prominence of AI in economic life.

That goes to underscore the notion that in times of big structural change, equity market performance is about more than just bond yields.

Global markets are currently wrestling with huge economic structural mega-trends that are currently more important than conventional macro or bond yield metrics in driving equity market performance.

At the forefront of these changes is the rapidity of technological advances, particularly (but not solely) in AI, and the tremendous earnings upside for companies that can best take advantage of this phenomenon.

And that is what has happened: muscular earnings growth has more than validated a huge capex spend.

Of course, while the AI earnings boom is real, ongoing investment is needed to sustain it. That in turn requires the investment to make a decent return. Higher bond yields haven’t (yet) derailed that narrative.

Indeed, seasoned equity investors like Nick Griffin from Munro Partners believe that while the occasional setback is inevitable what we are seeing in the AI and tech space is a boom not a bubble.

So yes, the macro environment is a challenging one and likely to stay that way as bond yields remain at current levels or go higher.

Oil prices now look “higher for longer” which should make investors wary. Large parts of the equity market will languish.

But strong outperformance in particular sectors (AI and tech) can overwhelm underperformers and drive equity markets (particularly the US) higher despite the challenges posed by higher bond yields.

The post The strength of the USD appeared first on AdviserVoice.

Stephen Miller

The US 10-year bond yield is above 5 per cent. Apart from a fleeting period (less than a day) in October 2023, the last time that US 10-year yields were in this sort of territory was in June 2007.

But is the 10-year bond yield “high”? II’m not so sure.

In the first instance rising bond yields were a response to a toxic cocktail; relatively high and “sticky” inflation (exacerbated by high oil prices in the wake of the Iranian conflict); record “peacetime” US budget deficits and consequent record government debt levels against a backdrop of virtually full employment; declining demand for US bonds from official sources as the US takes a more adversarial tone in its geopolitical and commercial international relations; competing issuance from hyperscalers to fund massive AI related capex; and question marks around the independence of the US Federal Reserve.

Certain elements of that toxic cocktail are in abeyance (Fed independence). But others persist.

Some may argue that the bad news is more than adequately reflected in a US 10-year bond yield above 5 per cent. I’m not so sure.

Others may point to the possibility of resort to financial repression (official measures to suppress bond yields). Treasury Secretary Scott Bessent’s recent attempt looks unsuccessful but there might be more to play out on that front.

So, is it time to overweight bonds in a multi-asset portfolio?

Maybe, but I retain a healthy scepticism.

First, the toxicity of the cocktail nor its durability should not be underestimated.

Oil prices are elevated and inflation remains stubbornly “sticky”. There is the notion that higher oil prices are yet to be reflected in broader inflation measures.

The US budget deficit does not seem likely to shrink in the near future (witness President Trump’s promise of $US5000 to every US adult if the Republicans win the mid-terms).

Demand for US government bonds from official sources (mostly foreign central banks) has inevitably declined. It is clear why the central banks of potential adversaries like China will continue to reduce exposure to the USD and US government bonds. However, given President Trump’s somewhat capricious treatment of allies, developed country central banks may also explore diversification of their foreign exchange reserves, a la Norway.

Hyperscalers continue to issue debt to fund the massive capex requirements associated with the AI boom.

Another element at play is that US monetary policy and, indeed, broader financial conditions may not be that restrictive.

Fed Chair Warsh has openly canvassed this question.

That implies that current bond yields may not be extraordinarily high.

Between 2008 and 2022 (the period covering from the GFC to the pandemic) US 10-year bond yields averaged around 2.4 per cent. The “real” yield (nominal yield less 12-month core CPI inflation) was close to 0.1 per cent.

That was a period of extraordinarily low yields by historical standards. Yet it is etched in the minds of a number of market participants as some benchmark of “normality”.

Between 2000 and 2007 the average US 10-year bond yield was around 4.7 per cent while the real yield was around 2.5 per cent. These were not that different from averages during the 1960s (4.7 per cent and 2.2 per cent respectively).

The latter are arguably a better benchmark than that which prevailed between the GFC and the end of the pandemic.

The current figures are close to 5.1 per cent and 2.6 per cent respectively. That is in the ballpark of periods outside that book-ended by the GFC and the Pandemic.

Current nominal and real 10-year yields are probably a tad higher than long-run “steady state” nominal and real GDP growth rates. In other words, compared with r* (the long run “steady state” 10-year bond yield), the current 10-year bond yield is maybe a little on the high side. A substantial productivity dividend from AI would likely increase r* making current levels more “normal”.

And there is that the aforementioned toxic cocktail.

There are other considerations that attach to bonds in the context of a multi-asset portfolio.

It has become clear that any assumed negative return correlation between equities and bonds is highly contingent on a low and stable inflation rate. Such an environment gives central banks the wherewithal to address the consequences of a downdraft in equity markets with an aggressive reduction in the policy rate and attendant lower bond yields.

The higher inflation environment that emerged from the pandemic has rendered the negative return equity/bond correlation assumption as no longer useful.

Investors need to think about augmenting traditional multi-asset portfolios with strategic allocations to asset classes that are not as correlated with equity returns and which have some inflation protection qualities.

Certainly, infrastructure and commodities are appealing in this regard. Not only are they less correlated to equity and bond returns but they have desirable inflation protection qualities (although the Australian equity market may exhibit some positive correlation with certain commodities). Trend following quantitative portfolios also fill a similar role.

So, a 10-year bond yield above 5 per cent may well be the new normal. Macro conditions remain problematic (“sticky inflation, oil prices, US budget deficit, hyperscaler issuance etc.); bond yields are not particularly high versus historical benchmarks and compared to r*; and bonds are not as effective a diversifier to equities as they may have once been.

RBA: need to go higher

At the time, I described the August decision by the Reserve Bank of Australia (RBA) Monetary Policy Board (MPB) to leave the policy rate unchanged as “defensible but contestable”.

In essence the Board at the August meeting, ceded the argument that increases in the policy rate so far this year are working to contain inflation, and with activity growth tepid, the balance of risks pointed to no need to increase the policy rate at the August meeting.

That the decision was not without risk was exemplified by the reality that inflation pressures in Australia are among the highest in the developed world. That reflects the uncomfortable circumstance of a homegrown structural inflation proclivity.

That some Board members were cognisant of those homegrown inflation risks seemed to be made clear in the minutes of the August meeting which canvassed the potential requirement to increase the policy rate should upside inflation risks materialise.

The July consumer price index (CPI) report brought those upside risks into stark relief.

Indeed, the July report makes it is hard to construct a narrative around declining inflation. The annual rate of increase is stuck at 3.6 per cent. Perhaps even more worrying the annualised 6-monthly rate of increase is at 3.9 per cent. That is the highest in the (admittedly short history) of the published monthly series.

The July report led RBA governor Michele Bullock to tell a parliamentary inquiry last week that the risks of inflation continuing to rise were “materialising”.

What is more, “sticky” inflation must cast some doubt on the prevailing RBA (and financial market consensus) narrative that monetary policy is restrictive. A “real” policy rate of somewhere around ½ – ¾ per cent does not strike me as particularly restrictive.

I have noted in the past that Australia’s poor relative inflation performance stems from abject productivity growth which makes the task of inflation containment all the harder, necessitating higher policy rates. That abject productivity growth reflects, inter alia, the interplay of regulatory creep in labour and goods markets. Regulatory creep also imposes costs on businesses, part of which are passed on to consumers, giving further impetus to price pressures.

In the absence of a meaningful deterioration in the labour market, I strongly suspect that the RBA will be required to raise the policy rate again at its September meeting.

Moreover, at this stage meetings beyond September must be considered “live”, even if the RBA were to raise the policy rate in September.

That may be the “least worse” path even in the event of a cooling labour market.

In the wake of the oil shocks of the 1970s, developed country central banks’ big mistake was a premature retreat from an inflation focus. That “let the inflation genie out of the bottle” and resulted in the painful, but necessarily harsh Volcker medicine of the late 1970s / early 1980s.

I am not suggesting that the current circumstance is one that is anywhere near quantitatively on a par with 1970s. But there are elements that are redolent of that time, albeit on a substantially reduced scale.

The RBA’s mandate has both an inflation and employment objective. Yet the RBA has only one instrument – monetary policy – at its disposal. Trying to target two variables with one instrument is nigh on impossible as any economics undergraduate with even cursory knowledge of the Tinbergen Rule will tell you.

In his Jackson Hole remarks, Warsh noted that the Fed also has a mandate for maximum employment. He added that achieving both sides of that mandate does not mean that monetary policy works at cross-purposes since high inflation itself is very harmful to economic prosperity.

Maybe the best the RBA can do to ensure maximum employment in the medium-term is to ensure a low and stable rate of inflation.

And that is why it must increase the policy rate at the end of the month and maybe beyond.

By Stephen Miller, investment strategist

The post Is a 5 per cent US 10-year bond yield the new normal? appeared first on AdviserVoice.

Stephen Miller

Yesterday’s Australian monthly CPI inflation report makes the September RBA meeting “live”. In my assessment the Board should increase the policy rate at that meeting. I expect it will.

The July report makes it is hard to construct a narrative around declining inflation and again serves to emphasise Australia’s poor inflation performance relative to other developed economies – its structural homegrown inflation proclivity. The annual rate of increase is stuck at 3.6 per cent. Perhaps even more worrying the annualised 6-monthly rate of increase is at 3.9 per cent. That is the highest in the (admittedly short history) of the published monthly series.

What is more, “sticky” inflation must cast some doubt on the prevailing RBA (and financial market consensus) narrative that monetary policy is restrictive. A “real” policy rate of somewhere around ½ – ¾ per cent does not strike me as particularly restrictive, at least in terms of an inflation containment challenge compounded by policy missteps elsewhere.

US FED

Fed Chair Warsh has an opportunity to address some communication missteps when he addresses the Kansas City Fed’s Jackson Hole symposium on Friday night (AEST).

Bond markets have been unsettled by what they regard as still “sticky” inflation along with a perceived lack of inflation resolve on the part of the Fed Chair. Interventions by President Trump and Treasury Secretary Bessent’s clumsy intervention in the bond market have not helped the picture. Last night’s July private consumption expenditures (PCE) price index report provided some evidence that inflation continues to be less than feared. The traditional Fed inflation focus – the core private consumption expenditures (PCE) price index – is, at 3.3 per cent, well north of the Fed target of 2 per cent.

However, Warsh prefers the Dallas Fed trimmed-mean measure which is currently running at 2.3 per cent – not that far from the Fed target. That gives the Warsh Fed at least some temporary cover in eschewing a policy rate increase. Warsh has articulated is a desire to reframe the Fed’s strategic direction via the establishment of a series of taskforces covering communication, Fed balance sheet management, a review of data sources, productivity and jobs, and inflation drivers and measurement. By giving some indication of progress on these taskforces at Jackson Hole, Warsh might be able to better articulate a rationale for an unchanged policy rate.

Bond markets still have a bit to worry about, particularly the huge US Budget deficit, and, despite glimmers of hope, inflation is still a concern, but some communication around progress on the taskforces might be helpful for markets in gaining an understanding of the drivers of monetary policy under the Warsh regime at the Fed.

By Stephen Miller, investment specialist

The post Australian monthly CPI inflation appeared first on AdviserVoice.

Stephen Miller

Since the conclusion of the last Fed Federal Open Market Committee (FOMC) meeting, the US financial market commentariat have spent some time highlighting Fed Chair Warsh’s communication shortcomings.

It appears that Warsh unnecessarily let his (justified) antipathy toward forward guidance manifest itself in a reticence to communicate a rationale for the Fed’s decision to keep the policy rate steady, failing to communicate any detail regarding Fed members’ assessments of current inflation pressures, and indeed on the economy more broadly.

Warsh could have simply shared elements of the Fed’s current economic assessments without crossing the line into forward guidance.

By choosing to communicate nothing by way of a rationale for the FOMC decision the Fed Chair has created an information vacuum. In part reflecting that void, the bond market took the path of least resistance and arrived at a collective view that Warsh lacked resolve on inflation.

It probably didn’t help that President Trump opined that Warsh was doing a “fantastic job” and “would love to lower interest rates”.

That circumstance seems to have distracted the US bond market from an inflation picture that is much less challenging that might have been feared, particularly in the wake of the Trump Administration’s tariff policies and the potentially deleterious effect on inflation and inflation expectations from the surge in oil prices in the wake of the Iranian conflict.

Last night’s US consumer price index (CPI) release is another indicator of just how well US inflation has behaved despite the challenges from, among other things, tariffs and oil.

US core CPI inflation came in at 2.5 per cent, the lowest annual rate since March 2021. That was at the height of COVID deflation fears (remember that!).

Meanwhile, the traditional Fed inflation focus – the core private consumption expenditures (PCE) price index – is, at 3.3 per cent, well north of the Fed target of 2 per cent. Warsh prefers the Dallas Fed trimmed-mean measure which is currently running at 2.2 per cent (June read) – not that far from the Fed target and the lowest read since July 2021.

Of course, the vagaries of oil prices might upset that positive emergent US inflation narrative but nevertheless the forgoing results are a positive surprise.

Along with recent softer payrolls numbers they indicate that the Fed is not under any pressure to urgently raise the policy rate.

Bond markets still have a bit to worry about, particularly the huge US Budget deficit, but if Fed Chair Warsh had articulated that emergent positive narrative – and he could have done so that without crossing the forward guidance line – then perhaps bond markets might be well be a tad less anxious.

RBA: Bullock avoids the ‘Warsh trap’ but monetary policy challenges remain

Following the Fed Chair Warsh’s poorly received communication after the Fed kept rates steady in July, I conjectured that Reserve Bank of Australia (RBA) Governor Bullock would have to be on top of her communication game in the event the RBA held rates steady in the August meeting.

In the event those fears proved unfounded.

Bullock gave a credible rationale for the RBA’s decision to keep the policy rate steady. She framed the Monetary Policy Board (MPB) debate as one between keeping rates steady and increasing the policy rate, ceding the “bond vigilantes” some succour.  That was given some emphasis by a stated readiness to raise the policy rate should upside risks to inflation assert themselves.

Bullock speaks from a position of greater credibility than Warsh given that the RBA had raised the policy rate at three successive meetings in February, March and May of this year. In that sense she has revealed inflation-fighting credentials in a way that Warsh has yet to demonstrate.

The June quarter trimmed-mean inflation outcome at 3.6 per cent was below the RBA forecast of 3.8 per cent issued in May. So, the argument went, the increases in the policy rate so far this year are working to contain inflation, and with activity growth tepid, the balance of risks pointed to no further requirement for an increase at the August meeting.

Bullock communicated this in a clear and balanced way, albeit one can argue whether the Board arrived at the “correct” decision.

Warsh on the other hand, unnecessarily let his antipathy toward forward guidance manifest itself in a reticence to communicate a rationale for the Fed’s decision to keep the policy rate steady, failing to communicate any detail regarding Fed members’ assessments of current inflation pressures, and indeed on the economy more broadly.

Warsh could have shared elements of the Fed’s current economic assessments without crossing the line into forward guidance.

Taking a leaf out of Bullock’s approach, Warsh might have pointed out that US inflation has been less than feared.

In other words, there were good reasons for the Fed leaving the policy rate unchanged.

Last night’s July CPI report reaffirmed that.

Warsh has in the past conjectured that disinflation in the US will follow from tremendous (largely AI motivated) investment. In Warsh’s view that investment has wrought a productivity dividend that (other things equal) has raised the US economy’s “speed limit”. In other words, the US economy can grow at faster rate before igniting inflationary pressures.

The notion that AI driven productivity growth can constrain inflation is a credible – if debatable – position. Some worry that the huge capex requirements associated with AI might in the short-term put demand pressure on inflation. Indeed, it is the latter that the RBA emphasised in its articulation of upside risks to inflation.

The RBA’s decision to hold the policy rate at the August meeting, however, is not without some risk. Australia has an “underlying” inflation rate that is among the highest in the developed world. That reflects the stark reality of a homegrown structural inflation proclivity. I tend to think that the RBA underplays this factor in its public commentary.

I have noted in the past that that reflects the interplay of regulatory creep in labour and goods markets that impose costs on businesses, part of which are passed on to consumers, and which result in abject productivity growth which makes the task of inflation containment all the harder. Australia’s abject productivity growth may be why AI related capex has a greater inflation impulse in Australia.

Frustratingly, governments (state and federal; Labor and Coalition) have displayed a ‘head in the sand’ approach to dealing with these issues and unfortunately the current Federal government is no exception.

In that context, the policy rate “hold” from the RBA last week may be defensible but I continue to worry that the RBA will be required to raise the policy rate again at some stage in 2026. Unit labour cost growth in excess of 3 per cent (even if down from 5 per cent a year ago) is hard to square with a seamless return of inflation to the mid-point of the target. Too great a delay in tightening policy runs the risk of too “sticky” an inflation rate and, as a consequence, a more substantial dislocation in economic activity and in the labour market down the track.

By Stephen Miller, investment stragtegist.

The post US inflation: nothing for the worry Warshs   appeared first on AdviserVoice.

Stephen Miller

The financial market commentariat would have us believe that Federal Reserve Chair Warsh’s Congressional testimony was “hawkish”.

Fair enough! Despite a benign June consumer price index (CPI) report and last night’s benign producer price index (PPI) report, Warsh noted that it didn’t follow that it was ‘mission accomplished’ on inflation. He added for good measure that the Fed’s interest rate setting committee had ‘no tolerance for persistently elevated inflation’ and further, were united in ‘a resolute commitment to restoring price stability’.

I would note that it would be highly problematic for a central bank chair to communicate anything other than a ‘resolute commitment’ to fighting (what appears to be elevated and “sticky”) inflation.

Warsh gave nothing away regarding the likely Fed stance that will emerge from the next meeting of the Fed’s interest rate setting committee on July 28-29. (For what it is worth, markets dialled down their expectations of a tightening at the July meeting to a trivial level in the wake of the benign inflation reports but are still pricing slightly more than one further tightening before year-end).

All in all, Warsh’s comments are consistent with the notion that statements from this Fed Chair may well assume a more Delphic quality than that to which financial markets have become accustomed.

Warsh has indicated a strong antipathy for central bank “forward guidance” and by implication, the utility of the Fed’s “dot plot”. He did not submit a “plot” at the most recent Fed policy meeting and has made it clear that he doesn’t put too much store in the accuracy of the “plot”.

In essence, Warsh appears to doubt that the “dot plot” is additive to the information set of the Fed or markets. Indeed, he implies that in some instances the exercise is possessed of a certain disutility, insofar as such projections are innately ephemeral and create a damaging facade of an anchoring mechanism that bears no relation to unfolding reality.

In this sense it might be that to the extent that markets have inferred a tactical “hawkish” tilt under Warsh, it might be misplaced.

What Warsh has articulated is a desire to reframe the Fed’s strategic direction via the establishment of a series of taskforces covering communication, Fed balance sheet management, a review of data sources, productivity and jobs, and inflation drivers and measurement.

Having said that, to the extent that one could draw any conclusions regarding the benign June inflation reports it is that they appear to be some way from necessitating an increase in the Fed policy rate.

Inflation, however measured, is still north of the Fed’s 2 per cent target but looks to be trending (very grudgingly) downward despite tariff impacts and the surge in oil prices in the wake of the Iranian conflict. Of course, it might be argued that with respect to oil prices, the jury is still out when it comes to potential contagion effects on broader inflation and inflation expectations, particularly in the wake of the reescalation of the Iranian conflict.

The taskforces on productivity and jobs and price and inflation frameworks play into a theme that Warsh has in the past been quite vocal about. Specifically, Warsh conjectures that disinflation in the US will follow from tremendous (largely AI motivated) investment. In Warsh’s view that investment has wrought a productivity dividend that (other things equal) has raised the US economy’s “speed limit”. In other words, the US economy can grow at faster rate before igniting inflationary pressures.

The notion that AI driven productivity growth can constrain inflation is a credible – if debateable – position. Some worry that the huge capex requirements associated with AI might in the short-term put demand pressure on inflation.

What is also interesting is that when it comes to inflation measures, Warsh has indicated that he prefers the Dallas Fed trimmed-mean measure of the PCE. That measure was 2.4 per cent in in May, a full percentage point below the traditionally preferred core PCE at 3.4 per cent and occurs despite those aforementioned broad-based price pressures emanating from the Trump tariff agenda and oil price increases. Like other measures, the Dallas Fed inflation measure is still north of the Fed’s 2 per cent target for “inflation” but further away from mandating a policy rate increase than the traditionally preferred measure.

If that remains the case (an admittedly big “if”) and if Chairman Warsh can convince other FOMC members of the veracity of his viewpoint (a similarly big “if”) then a policy rate hike might be a more remote prospect than markets currently contemplate.

Further, Warsh’s more strategic focus might mean less frequent policy adjustments than have been seen in the past.

Instead, an extended period of a stable policy rate might be a more credible scenario.

By Stephen Miller, investment strategist

The post Inflation and the “new” Fed: livin’ under Kevin appeared first on AdviserVoice.

Stephen Miller

I’m not sure that the news flow of the last week or so has managed to advance whatever one may have been thinking about the decision of the Reserve Bank of Australia (RBA) Monetary Policy Board (MPB) at its next meeting in August.

The minutes from the June meeting noted that policy was ‘somewhat’ restrictive but at the same time exhibited some handwringing around elevated inflation expectations. What might have been at the forefront of the RBA Board’s contemplations was the Fair Work Commission (FWC) decision to award a 4.75 per cent increase in the minimum wage and awards. That such an increase occurred against a backdrop of ongoing abject productivity growth and how it might inform wider wage negotiations is clearly a concern going forward.

The May monthly consumer price index report (CPI) was not as bad as feared and is probably consistent with the most recently issued RBA forecasts back in May.

Nevertheless, Australian inflation remains elevated. Trimmed-mean consumer price index (CPI) inflation in Australia is currently running at 3.6 per cent. That puts Australia at the top the developed country inflation league. That is not a (developed) World Cup we should want to win!

Some more positive news since the June meeting has been declining oil prices which might mitigate the dangers of oil price inflation broadening into something even more pernicious.

But Australia’s inflation problem is way more than just oil prices, as illustrated by the aforementioned adverse comparison of Australian inflation with elsewhere in the developed world.

Jim Chalmers might have us believe that the Middle-East tensions and the attendant ratcheting up of the price of oil is the primary driver of our current inflation challenge, and yes there is a skerrick of truth in that, at least in absolute terms.

But the stark reality is Australia has a structural homegrown inflation proclivity.

That homegrown structural inflation proclivity reflects, inter alia, the interplay of regulatory creep in labour and goods markets that impose costs on businesses, part of which are passed on to consumers. The regulatory regime is also reflected in the abject productivity growth which makes the task of inflation containment all the harder.

As I’ve stated in the past, this state of affairs is not just down to the current Federal Government. Rather it reflects a long-standing policy deficiency since the end of the Hawke-Keating and Howard-Costello eras. Governments (both State and Federal and Labor and Coalition) have long averted their eyes from addressing productivity enhancing policy measures. Just as importantly, little attention has been given to avoiding productivity diminishing measures attaching to (mostly well-intentioned but poorly thought out) regulatory oversight of labour and goods markets.

Sure, (to paraphrase the Prime Minister) people don’t sit around the kitchen table talking about low (or negative) productivity growth. But productivity remains central to enhancing standards of living not the least through mitigating inflation.

The decision to “pause and reflect” at the June meeting was understandable given concerns about looming cyclical fragility. In that context it reflected a view that there was some utility in using the “space” provided by preceding policy rate increases to assess how the economy was adjusting and the impact of disruptions.

However, both the RBA minutes and Governor Bullock’s comments would indicate that the policy rate might still need to be increased at a later date. That reflects, inter alia, governments’ inability to support the RBA’s inflation battle with supportive structural policies.

So, in determining the course of the policy rate over coming months, the RBA faces considerable challenges having to negotiate a tricky (dare I say “narrow”) path between structural inflation factors and cyclical fragility.

The June CPI release later this month looms as a key staging post in how the negotiation of that path may evolve.

Eurozone June “flash” CPI: ECB to stand pat in July

Overnight, Euro area CPI inflation for June came in a little lower than expected at 2.8 per cent at the headline level (compared with 3 per cent expected). The core reading was also better than expected at 2.4 per cent (2.6 per cent expected).

While inflation remains above the ECB target of 2 per cent, there now seems almost no prospect of a policy rate (deposit facility) increase from the current 2.25 per cent at the July 22-23^rd meeting.

Speaking at the ECB’s Sintra Conference earlier in the week, ECB President Lagarde stated that she thought the ECB had gone some way to making the Eurozone economy less vulnerable to inflation shocks, perhaps reflecting a more rigorous financial framework.  She also noted that tensions in the Middle East had subsided (even if resolution was ‘far from assured’). Overnight at that same conference, Lagarde stated that she thought the risks to inflation and growth are ‘broadly balanced’ which would indicate that she sees no compelling case for a policy rate rise. (She also expressed a scepticism regarding the utility of “forward guidance” and other features of COVID era monetary policy such as “quantitative easing”.)

Other ECB decisionmakers are less sanguine.

Markets see the prospect of a hike in as closer to 30 per cent in September.

The latest set of ECB forecasts were based on Brent oil prices of around $US82 per barrel. It is currently at circa $US73 per barrel giving the ECB some “space” to digest whether further inflation pressures might necessitate a further increase.

Coming up: US non-farm payrolls tonight (ahead of Independence Day holiday)

As mentioned above, even more benign looking measures of inflation such as the Dallas Fed ‘s trimmed mean core PCE measure is, at was 2.4 per cent in May, still a way above the 2 per cent Fed “inflation” target.

And progress on the inflation front has been excruciatingly slow.

So absent some sharp and unforeseen deterioration in the labour market a policy rate cut hardly looks proximate.

Tonight sees the release of the June non-farm payrolls report ahead of Friday’s Independence Day holiday.

Indications are that the labour market remains in satisfactory condition.

The May Job Openings and Labor Turnover survey (JOLTs) report saw openings mostly unchanged at a healthy enough 7.6m.

The ADP June payrolls report showed a solid enough gain of 98k (even if lower than the 113k increase expected). The ADP report is sometimes dismissed (too easily in my view) because of its poor record in foreshadowing month-to-month movements in the Bureau of Labor Statistics payrolls measure. However, it is just as good a measure of the state of the labour market as the payrolls report.

The June Institute of Supply Management (ISM) manufacturing index (PMI) released overnight paints a reasonably satisfactory picture of the US manufacturing sector: the index coming in unchanged at 53.3. The employment component increased to to 49.7 from 48.6 in May (50.0 is the neutral point between expansion and contraction). The prices component declined to 73.0 from 82.1 in May. That is still elevated but maybe a harbinger of some easing of price pressures to come.  

A consensus outcome for payrolls of a circa 110k increase in employment and an unemployment rate unchanged at 4.3 per cent with average earnings growth of 3.5 per cent is not going to move the dial for any Fed members.

By Stephen Miller, investment strategist

The post RBA minutes: stayin’ live appeared first on AdviserVoice.

Stephen Miller

As was pretty much expected, the Federal Reserve’s Federal Open Market Committee (FOMC) chose to keep the policy (federal funds) rate target unchanged at 3.5 – 3.75 per cent.

That was pretty much universally expected.

The Statement issued with the decision looked a little more “hawkish” than the market had anticipated.

Overall, the Committee looked to be relatively sanguine regarding economic activity growth and the labour market but noted that ‘inflation remains elevated relative to the Committee’s 2 per cent goal’ and that ‘the Committee will deliver price stability.’ There was no reference to the employment side of the Federal Reserve’s (Fed) mandate.

The phrasing of the Statement looked to be framed against a backdrop of a particular concern regarding the “stickiness” of inflation.

That was reflected in the projection materials. The central tendency of the Fed’s traditional inflation focus, the core private consumption expenditures (PCE) price index, is now thought to come in at 3.3 per cent for 2026 compared with 2.7 per cent in March.

Reflecting that the central tendency of the policy (federal funds) rate which was revised up to 3.8 per cent from 3.4 per cent in March. In terms of the “dot plot”, of the 19 participants, 9 saw at least one further increase in the policy rate (3 saw one increase, 5 saw two increases, and 1 saw three increases), 8 participants saw no change and 1 saw a reduction. Chair Warsh did not submit a plot.

In his press conference, Chair Warsh foreshadowed some potentially significant changes in current Fed decision-making processes. He announced the establishment of five taskforces that will cover key elements of the current Fed processes and practices. Those task forces will cover:

• Fed communication, including, presumably, the utility of the current “dot plot”.
• Management of the Fed’s balance sheet.
• How the Fed uses existing data and whether new information sources might provide more useful information.
• Productivity and jobs.
• Price / inflation frameworks, including drivers and the measurement of inflation.
• As mentioned, the markets have taken a view that the Statement is a relatively ‘hawkish’ one: equity markets are weaker as is the USD, bond yields mostly rose, particularly in the front-end.

The “hawkish” reaction is understandable.

For one thing half of the FOMC, via the “dot plot”, see a hike in the policy rate this year.

For another, the Statement and Warsh in his press conference, emphasised “price stability” with an implication that current inflation is too high. Chair Warsh in his press conference seemed to wish to reinforce the Fed’s credibility as an inflation fighter.

And finally, the Chair too exhibited no real disposition to do the President’s bidding, putting Fed independence on display.

However, my sense of the press conference was that Warsh was not necessarily signalling much about the future path of policy (not surprising given his disdain for forward guidance and, indeed, the utility of the “dot plot”).

In that context the bond market reaction may have reflected a market that was anticipating a more “dovish” disposition from the Fed Chair. In other words, bond market positioning was “the wrong way around”.

Indeed, on the “dot plot” Warsh noted in the press conference that when he reviewed the plots of his colleagues, he spotted they were in pencil, ‘the type with an eraser’ he said, suggesting that circumstances can shift quickly and that markets should be wary of their informational utility.

Moreover, the announcement of a series of taskforces and the implied changes in Fed processes suggests that the next Fed move is maybe more of an open question, as might be the ultimate impact on the bond market, particularly via the balance sheet taskforce.

RBA: stayin’ “live”

For what it is worth I think the RBA made the right call at Tuesday’s meeting.

With inflation showing signs of peaking, with the news flow from the Middle-East marginally less worrying, with the economy clearly slowing and growth narrowly based, with the labour market possibly at an inflection point and having raised the policy rate at each of the three previous meetings, a ‘pause and reflect’ made sense.

What also made sense was to reinforce ongoing concern regarding inflation.

That is despite the aforementioned better news from the Middle-East.

Jim Chalmers might have us believe that the Middle-East tensions and the ratcheting up of the price of oil is the primary driver of our current inflation challenge. That is partially true at the ‘headline’ level. But the reality is Australia has a structural homegrown inflation proclivity.

That much may be gleaned from the trimmed-mean inflation measure which excludes any strong upward impetus from oil prices.

Trimmed-mean consumer price index (CPI) inflation in Australia is currently running at 3.4 per cent. That means we’re currently competing with Norway for the highest developed country inflation crown. That is not a (developed) World Cup we should want to win!

By way of comparison, the trimmed-mean measure in the US is 2.9 per cent and that is with some tariff impact that doesn’t apply in the Australian context.

Treasurer Chalmers might seek to conceal that point in his public statements on interest rates and inflation, but the reality is much of the problem is our own doing.

That homegrown structural inflation proclivity reflects, inter alia, the interplay of regulatory creep in labour and goods markets that impose costs on businesses, part of which are passed on to consumers. The regulatory regime is also reflected in abject productivity growth making the task of inflation containment all the harder.

Ruchir Sharma in a recent opinion piece in the Financial Times noted that “populists of the left and right tend to push for lower interest rates but appear not to recognise that the people hurt most by the resulting inflation are their main constituents: the poor and middle class.”

That is something the Treasurer may wish to reflect on, not to mention his erstwhile mentor, Wayne Swan, who not long ago accused the RBA of “punching itself in the face”! Nice line, but Swan’s sentiment is not one that has aged well. Indeed, one might be tempted to reference glass houses. (Mea culpa: we’ve all been there!)

To be fair, the current state of affairs is not down to the current Federal Government. Rather it reflects a long-standing policy deficiency since the end of the Hawke-Keating and Howard-Costello eras. Governments (both State and Federal and Labor and Coalition) have long averted their eyes from addressing productivity enhancing policy measures. Just as importantly, little attention has been given to avoiding productivity diminishing measures attaching to (mostly well-intentioned but poorly thought out) regulatory oversight of labour and goods markets.

Sure, (to paraphrase the Prime Minister) people don’t sit around the kitchen table talking about low (or negative) productivity growth. But productivity remains central to enhancing standards of living not the least through mitigating inflation.

So, while looming cyclical fragility may have motivated the RBA’s ‘pause and reflect’, that Governor Bullock was clear that the policy rate might still need to be increased at a later date, reflects governments’ inability to support the RBA’s inflation battle with supportive structural policies.

In determining the course of the policy rate over coming months, the RBA faces considerable challenges having to negotiate a tricky (dare I say “narrow”) path between structural inflation factors and cyclical fragility.

Bank of England’ nothing to see here…yet

The Bank of England meets tonight.

In some ways the Bank of England calculus is similar to that faced by the RBA.

The economy is in a state of cyclical fragility, and the UK also has somewhat of a structural inflation proclivity. In many ways, the inattention to structural elements has been more egregious than that attaching to Australia and in that context it is surprising that inflation has at the margin been better behaved. That may be attributable to a deeper cyclical fragility.

In any case, a set of benign (relative to expectations) virtually seals the deal for no rate rise at this meeting.

Headline CPI in May was unchanged at 2.8 per cent (versus 3.0 per cent expected). Core inflation came in at 2.6 per cent, slightly up from 2.5 per cent in April, and a little below the 2.7 per cent expected. Services inflation remains somewhat problematic coming in at 3.7 per cent up from 3.2 per cent in April.

So, while inflation remains well north of the 2 per cent target, against a backdrop of more positive news from the Middle-East this week, the key inflation measures seem sufficient enough to forestall any potential increase in the policy rate at tonight’s meeting. That said, markets may continue to romance the notion of a policy rate rise given services inflation and the fact that the current measures are well north of the target.

By Stephen Miller, investment strategist

The post The Fed: “hawkish”…sort of… appeared first on AdviserVoice.

Stephen Miller

The post The RBA: ‘pause and reflect’ despite a particular inflation proclivity, Fed and other central banks appeared first on AdviserVoice.

Stephen Miller

The onset of the Iranian crisis has unleashed a litany of dire prognostications surrounding the likely course of the price of financial assets.

Yet US equity markets are close to record highs.

What gives?

The favoured explanation among the commentariat is that markets are complacent – perhaps even “irrationally exuberant” – and a day of reckoning is nigh.

Viewed through a macroeconomic prism that explanation has some appeal.

Even if hostilities in the Middle East are about to be dialled down it is difficult to see oil prices return to their pre-conflict levels. Re-engineering of energy supply chains, a greater tendency to “just-in-case” rather than “just-in-time” oil inventory management and an ongoing risk premium attaching to the price of oil may see an extended period of elevated oil prices.

Inflation was “sticky” prior to the surge in oil prices. Furthermore, structural global inflation suppressants that had operated since the late 1980s up until the onset of the pandemic are in clear abeyance (think declining skilled migration flows from the former Eastern Bloc, China and India; the retreat of globalisation of goods markets; increasing labour and goods market regulation; and declining baby boomer workforce participation).

Those waning structural inflation suppressants and now the surge in oil prices have meant that central banks, including the US Federal Reserve, are required to be more attuned to upside inflation risks than they may have been in the three or so decades leading up to the pandemic. It has also meant that an anticipated decline in bond yields has not eventuated.

There is a view that current bond yields are “elevated” by some historical standard.

That notion, however, doesn’t bear scrutiny.

Between 2008 and 2022 (the period covering from the GFC to the pandemic) US 10-year bond yields averaged around 2.4 per cent.

That was a period of extraordinarily low yields by historical standards. Yet it is etched in the minds of a number of market participants as some benchmark of ‘normality’.

Between 2000 and 2007 the average US 10-year bond yield was around 4.7 per cent. That is a way north of where the current US 10-year bond yield is trading.

The latter is arguably a better benchmark (albeit one that is far from perfect).

(Interestingly the average through the 1960s was also around 4.7 per cent.)

In other words, current bond yields are not “high” by historical standards.

The corollary of that notion is that in the current period of relatively strong inflationary tailwinds, the forces preventing any substantial decline in global and US bond yields are formidable.

That would imply ongoing headwinds to economic activity growth and equity market performance.

So why are US equity markets at close to record highs?

For one thing the macro data is yet to show any substantial slowing in economic activity growth.

However, it is also yet to reflect fully the fallout from the Iranian conflict.

But more importantly, the answer is that equity markets reflect a whole lot more than the macroeconomy.

Global markets are currently wrestling with huge economic structural shifts that are arguably more important than conventional macro metrics in driving equity market performance.

At the forefront of these changes is the rapidity of technological advances. The incorporation of AI into economic life will likely see massive productivity growth that can mitigate any adverse macro influences.

Moreover, there is an element of US exceptionalism that attaches to AI and consequent productivity growth.

The US is at the epicentre of AI developments and there are signs that it is already reaping outsized rewards from that circumstance.

US productivity growth has averaged 1.7 per cent per annum since the end of 2021. The equivalent Australian figure is -1 per cent. To put it more starkly, US productivity has grown by almost 7 per cent in that time, Australia’s productivity has fallen by 4 per cent. (Australia’s experience is reflected more or less in the rest of the developed world outside the US).

That might in part explain why US equity markets are at record highs (despite an adverse prospective macro environment) and that is to some extent dragging the laggards with it.

An important investment dimension arising from the forgoing is that it is likely to result in a greater dispersion of individual stock returns. That being the case, the returns from “good” active management are accordingly higher compared with passively managed index funds.

So yes, the macro environment is a challenging one and likely to stay that way as bond yields remain at current levels or go higher.

And that should make investors wary.

But equity markets (particularly the US) can benefit from harnessing important structural mega-trends that can propel ongoing strong equity performance despite that adverse macro environment.

The RBA: where to next?

I had canvassed the possibility that the RBA might ‘pause and reflect’ at this week’s RBA Monetary Policy Board (MPB) meeting.

That was not intended as a prescriptive statement but more as a descriptive sense of what the RBA may deliver under the new arrangements that accompanied the An RBA Fit for the Future review initiated by Treasurer Chalmers.

That didn’t eventuate, but I think the RBA Monetary Policy Board made the right call.

Inflation was already both too high and broad-based ahead of the Iran shock, even if the March quarter consumer price index (CPI) outcome was slightly less than feared.

And despite that ‘better than feared’ March quarter outcome, newly issued RBA forecasts show a path for trimmed-mean inflation higher than forecast back in February. For this calendar year trimmed-mean inflation is expected to come in at 3.5 per cent (compared with 3.2 per cent forecast back in February).

For what it is worth, I think on balance the current environment is one that argues for further insurance against inflation expectations becoming unanchored and that should see a further tightening at some stage this year.

Both the Federal and State governments appear to reticent to abandon politically expedient but ultimately counter-productive spending measures. In large part the end result is higher policy rates.

This is also the product of an almost egregious inattention of past and present governments (both State and Federal and Labor and Coalition) to policies that might ease structural constraints on inflation. In most instances this involves “unintended consequences” of regulatory creep in labour and goods markets.

The forgoing is emblematic of a particular inflation proclivity in the Australian economy.

That is on top of structural global inflation suppressants that had operated from the late 1980s up until the onset of the pandemic now being in clear abeyance.

The forgoing suggest that the RBA might still need to reload later in the year.

Coming up: US non-farm payrolls is unlikely to move the dial for the Fed despite the Warsh ascendancy

The last meeting of the US Federal Reserve (Fed) appeared to indicate the Fed was some way from easing policy.

At this juncture it is difficult to see that changing even as Kevin Warsh assumes the Chair’s position, presumably later this month.

Warsh, conjectures that disinflation in the US will follow from tremendous (largely AI motivated) investment. In Warsh’s view that investment has wrought a productivity dividend that (other things equal) has raised the US economy’s ‘speed limit’. In other words, the US economy can grow at faster rate before igniting inflationary pressures.

That is a credible – if eminently debatable – position.

And there have been glimpses of that phenomenon in some of the less “noisy” inflation measures.

For example, the Dallas Fed ‘s trimmed mean core private consumption expenditures (PCE) measure was 2.4 per cent in March, minisculely above the February reading which was the lowest since August 2021, and comes despite broad-based price pressures emanating from the Trump tariff agenda.

That said, progress toward the 2 per cent target, even on the Dallas Fed measure, has been excruciatingly slow.

Judging by their commentary most members of the Fed’s rate setting Federal Open Market Committee (FOMC) remain concerned about the potential for the recent oil price surge to unanchor inflation expectations.

And it remains the case that the Fed’s favoured inflation measure, the core private consumption expenditures (PCE) price index, at 3.2 per cent in March, is well above the target 2 per cent and was the highest read since November 2023.

So absent some sharp deterioration in the labour market the incoming Fed Chair might be hard-pressed to convince his fellow FOMC members of the case for cutting the policy rate.

Friday of course brings the April non-farm payrolls report.

Indications are that the labour market remains in satisfactory condition.

The ADP April payrolls report was more robust than anticipated showing a gain of 109k (versus the 85k increase expected). The ADP report is sometimes dismissed (too easily in my view) because of its poor record in foreshadowing month-to-month movements in the Bureau of Labor Statistics payrolls measure. However, it is just as good a measure of the state of the labour market as the payrolls report.

The March Job Openings and Labor Turnover survey (JOLTs) report saw openings remain at a satisfactory 6.9m.

The April Institute of Supply Management (ISM) manufacturing index (PMI) released on Monday paints a reasonably satisfactory picture of the US manufacturing sector: the index coming in unchanged at 52.7. The employment component slipped to 46.4, which is a little on the soft side and consistent with some manufacturing job losses (50.0 is the neutral point between expansion and contraction). The prices component meanwhile increased to an elevated 84.6 (ringing clear alarm bells around accelerating inflation in the sector).

The April ISM services index also paints a satisfactory picture with the overall index remaining consistent with expansion at 53.6. The employment component improved a little to 48.0 from 45.2, although it remains consistent with some modest cooling in the non-manufacturing labour market. The price component remains elevated at 70.7 (again consistent with worrying acceleration in inflation).

A consensus outcome for payrolls of a circa 180k increase in employment and an unemployment rate unchanged at 4.3 per cent with average earnings growth of 3.5 per cent is unlikely to move the dial for remaining Fed members.

If Kevin Warsh does in fact wish to cut the policy rate, he has his work cut out.

By Stephen Miller, investment strategist

The post Are markets ‘complacent’? appeared first on AdviserVoice.

Stephen Miller

The sharp increase in the price of oil in the wake of the Iran conflict has ushered in a plethora of central bank warnings around the inflationary consequences of such an increase.

What worries central banks is that a surge in oil prices might result in inflation expectations becoming unanchored and ultimately self-fulfilling.

The decidedly hawkish tone adopted by developed country central banks is largely aimed at avoiding a repetition of what played during in the 1970s in the wake of the first oil shock that followed the 1973 Yom Kippur War and the second shock in the wake of the Iranian revolution in 1979.

When the history of central banking in the 1970s came to be written it was thought that central banks were “too accommodating” of oil price shocks.

The narrative seemed to be that central banks in general, and the Federal Reserve in particular, were too quick to ease the monetary brakes after the first oil shock thereby failing to seal the inflation genie securely in the bottle. The result was that when the second oil shock hit, already elevated inflation expectations became unanchored, and the genie got well and truly out of the bottle.

It took the harsh but necessary Volcker medicine of the late 1970s / early 1980s which saw US overnight rates (fleetingly) approach 20 per cent to get that inflation genie back in the bottle. (The process took a little longer in Australia).

The experience of the late 1970s / early 1980s notwithstanding, an alternative narrative with respect to oil prices tended to take hold under the Fed Chairmanship of Alan Greenspan.

This was that the activity diminishing consequences of an oil price surge were of greater consequence than the price effects. Therefore, the bigger risk was the economy tipped into recession and that would ultimately be disinflationary.

So which is it? Are oil prices inflationary or disinflationary?

I suspect that the answer largely depends what might be happening with structural elements that have a bearing on inflation.

Throughout the developed world, the post-World War 2 period through to the end of the 1970s was marked by a greater confidence in governments being able to seamlessly regulate desired economic outcomes.

There may have been some benefit from such an approach, but there were also substantial economic costs in terms of structural rigidities reducing the flexibility of economies to respond to shocks (inflation shocks in particular). The result was a growing inflation proclivity (or “stickiness”) in developed economies.

Perhaps that was why inflation expectations were so hard to contain in the 1970s.

The 1980s through to the early 2000s were marked by a more deregulatory approach. Certainly, that was evident in the financial sector but also in labour and goods markets. This increased economic flexibility in goods and labour markets and was a factor in the “Great Disinflation” of that period.

There were also other structural currents that served to put a lid on inflation. The collapse of Communism in the former Eastern Bloc and the opening of China and India elicited a wave of skilled migration to developed countries. Governments were focussed on lowering tariffs and fostering domestic competition. Baby-boomer participation in the workforce was increasing (particularly female participation) which led to a relatively abundant labour supply that arguably kept wage growth lower.

It was because of a litany of such structural suppressants to inflation that oil prices through the period from the mid-1980s to the early 2000s tended to have more disinflationary consequences, at least in the medium-term.

However, as noted by Professor Charles Goodhart, former Bank of England Monetary Policy Committee member and a distinguished Emeritus Professor at the London School of Economics, those structural suppressants (particularly those associated with labour supply shocks) are probably in reverse.

The globalisation of labour supply (after the fall of the Berlin Wall and the “export” of labour from large emerging market economies such as China and India) is abating.

The globalisation of goods markets is in retreat as governments resort to protectionist measures (most notably with the Trump trade measures in the US); domestic regulation of goods and labour markets is increasing in scope leading to loss of flexibility in markets and attendant upward price pressures or “sticky” inflation”; and baby boomer workforce participation is declining.

A potentially important mitigant to the forgoing inflation scenario is put forward by Fed Chair designate, Kevin Warsh. He conjectures that disinflation in the US will follow from tremendous (largely AI motivated) investment. In Warsh’s view that investment has wrought a productivity dividend that (other things equal) has raised the US economy’s “speed limit”. In other words, the US economy can grow at faster rate before igniting inflationary pressures.

That is a credible, if still highly debateable position. For all the talk of US productivity exceptionalism (which certainly exists), the Fed’s favoured core private consumption expenditures (PCE) measure is “sticky” at just above 3.0 per cent, unchanged from where it was a year ago and still well north of the Fed’s target 2 per cent.

Bearing that in mind, and the abatement of structural inflation suppressants, it might mean that today’s world is more redolent of the 1970s and a surge in oil prices may have a longer lasting inflation impact.

That will mean that central banks have to be more attuned to the importance of anchoring inflation expectations than they may have during the three decades from the mid-1980s.

And that means a period of higher interest rates.

RBA: time to “pause and reflect”?

Yesterday’s relatively benign February monthly CPI report probably eases the pressure on the RBA to execute a “hat-trick” of rate rises when it meets in May.

If we take the Governor at her word (as I think we should), if the closeness of the vote at the last meeting was “more about timing than direction” then there may be some breathing space in May that affords the RBA to take on board a little more data before reconvening in mid-June to contemplate the utility of further tightening.

But it is a close call.

That is also the view reflected in the local bond market. In the wake of yesterday’s report markets were pricing roughly a 60/40 chance of a May tightening.

If pressed I would see the probability of a May tightening at something lower than 50 per cent (bearing in mind the Governor’s timing / direction comments). In other words, there may be some scope for “pause and reflection”. That might change in the event of an adverse March inflation report and / or any uptick in wage pressures in the wake of the ACTU claim for a 5 per cent increase in the minimum wage.

In any case, I strongly suspect that further tightening is in store as the year progresses because getting on top of the inflation remains the more important focus.

In my view, the Australian economy has developed an inflation proclivity that is greater than that which might exist in other developed countries.

There are elements to that proclivity that are homegrown, such as an almost egregious inattention of governments (both State and Federal and Labor and Coalition) to policies that might ease structural constraints on inflation. In most instances this involves “unintended consequences” of regulatory creep in labour and goods markets.

There are other elements that are more global in nature. In large measure these involve the reversal a number of structural forces suppressing inflation that were present in the three or so decades leading into the pandemic.

The globalisation of labour supply (after the fall of the Berlin Wall and the “export” of labour from large emerging market economies such as China and India) is abating; globalisation of goods markets is in retreat as governments everywhere introduce protectionist measures; domestic regulation of goods and labour markets is increasing in scope leading to loss of flexibility in markets and attendant upward price pressures or “sticky” inflation”; and baby boomer workforce participation is declining (limiting labour supply and lifting wages).

In the wake of the oil shocks of the 1970s, developed country central banks’ big mistake was a premature retreat from an inflation focus. That “let the inflation genie out of the bottle” and resulted in the painful, but necessarily harsh Volcker medicine of the late 1970s / early 1980s which saw overnight rates (fleetingly) approach 20 per cent. (Inflation – and elevated interest rates – lingered longer in Australia.)

I am not suggesting that the current circumstance is one that is anywhere near quantitatively on a par with the stagflation of the 1970s. But there are elements that are redolent of that time, albeit on a substantially reduced scale – “stagflation-lite” if you will.

As to the argument that a surge in oil prices is ultimately disinflationary, I have my doubts (as explained above).

That may have been true through the 1990s and into the early 2000s when those structural inflation suppressants were active.

It is less true in 2026.

What the forgoing means is that central banks need to be more attuned to inflation risks now more so than at any other time since the 1980s.

That has particular relevance in Australia given its inflation proclivity.

So even with a “pause and reflect” in May, the RBA might still need to reload in June.

The RBA operating in a new communication paradigm

There was some suggestion at the RBA Governor’s press conference that followed last week’s decision to further increase the policy rate that the RBA had “miscommunicated” its position in the lead-up to the meeting.

The contention was that both the Governor and her Deputy had strongly intimated that a tightening of policy was extremely likely at the March meeting.

The fact that the decision was a finely balanced one, as exemplified by the 5-4 vote in favour of an increase in the policy rate, was taken in some quarters as RBA “miscommunication”.

The Governor (rightly in my view) pushed back strongly on that notion. She suggested that the new arrangements that accompanied the An RBA Fit for the Future review initiated by Treasurer Chalmers meant that every meeting was a “live” one and this was what she and her deputy had wished to communicate.

In other words, those new arrangements have changed the operating communications paradigm for the RBA’s monetary policy decisions.

The new arrangements sought to give alternative viewpoints to any RBA institutional one. Those alternatives now have a voice and the power to challenge and debate the RBA staff view.

That is arguably not a bad thing.

But in this context, it is inevitable that when a diversity of voices are heard then discerning a “consensus” view is made more difficult.

This perhaps reflects what markets (should?) have know all along; that monetary policy and its appropriate stance is something that reasonable people can disagree on.

The appropriate stance of monetary policy is not a black and white decision.

When non-RBA staff Monetary Policy Board (MPB) members feel inclined to communicate their views (as I understood the new arrangements to envisage) that will become clearer.

RBA communication might therefore become more about the various factors that feed into an eventual decision.

The downside might be that real debate at the MPB level of the RBA means that any particular decision become harder to telegraph.

The upside is a more rigorous debate where the operating institution is subject to a greater degree of interrogation of its recommendation.

As the Governor hinted in her press conference that sort of debate and diversity heralds a more disciplined approach to decision-making.

Markets and the media may have to get used to the new communications paradigm.

In that endeavour they might be assisted by more communication from non-RBA staff members of the RBA MPB.

By Stephen Miller, investment strategist

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