Key insights from the week that was.
Monetary policy was again the focus in Australia and the US this week. RBA Governor Lowe spoke early in the week, providing an overview of inflation dynamics and the response of monetary policy. During the speech, Governor Lowe highlighted that the “rise in inflation is a global story” but also that domestic conditions are contributing and need to be monitored closely.
For the outlook, the most significant domestic factor is arguably the historic strength of Australia’s labour market which, if inflation expectations become unanchored, could lead to outsized wage claims and persistent support for consumer inflation. At this time, longer-run inflation expectations remain consistent with inflation returning to the RBA’s target range; however, short-term expectations as measured by the Melbourne Institute have recently jumped.
Limited available capacity, the risks to inflation expectations and the “highly stimulatory” starting point for policy were given as justification for the RBA Board’s June decision to lift the cash rate by 50bps in the meeting minutes. While the outlook for policy remains data dependent, it is clear the Board believe they have a lot more work to do. In short: at 0.85%, the cash rate currently remains materially below our estimate of neutral (1.5%-2.0%) and the medium-term neutral expectation of the RBA (2.5%); also, annual CPI inflation is not expected to peak until end-2022, while an easing of capacity constraints in the labour market could take years to fully eventuate given the uncertainties related to migration.
After this week’s developments, we have added an additional 25bps of rate hikes to our forward profile. As detailed by Chief Economist Bill Evans, two more 50bp rate hikes are now forecast for July (unchanged) and August (previously +25bps) to take the cash rate back to the middle of our neutral range (1.85%); after a two-month pause, 25bp hikes at the November 2022, December 2022 and February 2023 meetings are expected to leave the cash rate broadly in line with the RBA’s medium-term neutral level. This peak is well below the market’s expectation, but a stance we believe (in time) will allow inflation to moderate back to target without undue cost to the real economy.
On the data front, the Australian Chamber Westpac Business survey for the June quarter showed Australia’s manufacturing sector in strong form. The rebound in activity from the reopening saw output and new orders expand at a faster pace in Q2, and expectations for further growth in the September quarter remain positive. Manufacturers responded to this by growing their workforce and increasing overtime. That said, the upside for growth is being capped by significant and persistent headwinds. Labour and material shortages were noted as the factors most limiting production and are at their most extreme levels since the oil shock of the mid-1970s. Costs are rising rapidly, squeezing profit margins and putting upward pressure on finished goods prices and hence consumer inflation.
Offshore, the data flow was also light this week, resulting in an acute focus on the Congressional testimony of FOMC Chair Powell. His remarks confirmed significant additional tightening in coming months, in line with our forecasts. However, Chair Powell’s considered commentary also emphasised the FOMC still believe it is possible to remove current inflation risks without causing a recession (and desire to do so), that they are vigilant over the risks to activity, and will adjust the stance of policy to balance out these risks as necessary.
We have greater concern over the underlying strength of US economic activity and so forecast a lower and earlier peak fed funds rate than the market and FOMC (3.375% at December 2022 compared to around 3.8% in 2023). We also forecast a more aggressive and earlier rate cut cycle of 125bps from late-2023.
As a final point, whereas the market is increasingly becoming fixated on the probability and timing of a US recession, to us the bigger concern is the cumulative loss of growth relative to potential into the medium term. Despite strong domestic demand in Q1, GDP contracted on strong imports and soft inventories over the three months to March. Now in Q2, domestic demand has slowed such that the Atlanta Fed nowcast for quarterly GDP growth is pointing to a flat outcome. Furthermore, leading indicators are signalling below trend growth in the second half of 2022; and, with real incomes declining, financial conditions having tightened and a potential negative wealth effect ahead, there is little reason to suspect US growth will pick up materially through 2023 until support from lower interest rates comes through. While the opening up of a material output gap is helpful for containing inflation, clearly it also puts long-term productivity and wealth at risk.
