Cliff Notes: The Source and Persistence of Inflation

Key insights from the week that was.

In Australia this week, all eyes were on the September CPI. Headline inflation rose 0.8% (4.3%yr) in the month, largely owing to a 9.4% jump in fuel prices and a seasonal surge in domestic and international holiday travel & accommodation. The underlying inflation pulse also proved hotter than anticipated for Q3 overall, up 1.0% (3.7%yr).

While some parts of the basket are seeing disinflation – housing in particular looks to be cooling faster than expected as builders lure sales with discounts – other components are still showing persistence. Highlighting this is market services ex volatiles, which the RBA watches closely as an indicator of price pressures related to domestic capacity. In Q3, this metric rose 1.2% (3.2%yr), and the monthly detail points to momentum holding up – in line with our expectations for another chunky read in Q4.

With inflation running well above the RBA’s August forecasts, and some of the energy risks flagged then materialising, we continue to expect the Monetary Policy Board will deliver a 25bp rate hike to 4.85% in November. Beyond November, another rate hike in February is a risk, but is not currently part of our base case.

Across the Tasman, the RBNZ this week surprised market expectations for a 25bp rate hike, deciding instead to wait for further information before taking the next step with policy. The decision was made 4:3, with the Governor in the ‘on hold’ camp. A 25bp hike in December to 3.00% and further tightening in 2027 (Westpac NZ forecasts a peak of 4.00% in September) seems probable; however, each decision will depend on fuel prices, inflation expectations and evidence of second-round pricing pressures, along with the evolution of global economic risks.

In the US, the FOMC also held rates steady at its October meeting. Based on prior comments by key members, the decision was not a surprise, and neither were Governor Cook and Cleveland Fed President Hammack’s dissents in favour of a 25bp hike. The Committee remains positive on economic activity, characterising it in the statement as “expanding at a strong pace” (an upgrade from “solid” in September). Chair Warsh also subsequently emphasised the breadth of economic growth outside of tech-related investment (evinced by Q3 GDP the day after; see below).

The Committee refrained from spotlighting key price risks in the statement. However, inflation “remains elevated” and the FOMC are determined to achieve a “timely” and sustainable return of annual inflation to 2.0%yr after 6 years above target. This guidance and the “accumulation of more information will help the Committee determine the policy stance” suggests another 25bp hike is likely in December. Thereafter, the FOMC will remain attentive to any broadening in inflation and related risks through 2027; although, in the absence of another shock, we expect them to remain on hold.

The Q3 GDP report certainly supported Chair Warsh’s view on the breadth of growth, the 3.4% annualised gain for GDP benefitting from a 3.8% annualised increase in household consumption, 12.7% growth in non-residential investment as well as a robust increase in government spending. Notably though, the contribution from business investment was effectively offset by net exports’ drag given most of the componentry related to AI infrastructure investment is imported. This is not to say that US firms won’t benefit from the investment once complete, but simply that much of the initial return goes to the foreign businesses who provide the necessary capital equipment.

On consumption, the monthly PCE data implies downside risks remain for the consumer, the increase in nominal spending seen in the month requiring dissaving and, on a real basis, consumption flat in the month following a 0.5% gain in August. Cost-of-living pressures and uncertainty over the outlook is expected to see household consumption growth average around trend over the coming year, albeit with considerable volatility quarter to quarter. This should see PCE inflation slow back towards its 2.0%yr medium-term target as the FOMC desires, from 3.6%yr and 3.1%yr for the headline and core measures respectively as of September.

Across the Atlantic, the ECB also left its key policy rates unchanged in October. Of note from the meeting communications, energy prices continue to pose upside risks for inflation, but also downside risks for growth. “While the full effects of the energy shock are still unfolding, underlying inflation has remained broadly stable so far and wages do not show a material response”. “Financing conditions have [also] tightened”, “which is likely to weigh on inflation and growth”. In the press conference, President Lagarde noted that, between the October and December meetings, a significant amount of new economic information will be released, allowing forecasts and risks assessments to be tested.

Based on the October meeting communications, we continue to expect a rate hike at the December meeting but believe this will be prove to be the last hike of the cycle. Note though, the spectrum of risks Europe faces is broad and skewed towards inflation in the near term, hence the Council’s guidance will remain hawkish. President Lagarde also announced today that she will step down as ECB President in February ahead of the scheduled conclusion of her term next October.