It has been a busy but highly-informative week, with the RBA, FOMC and ECB all meeting and a slew of significant data releases in between.
Beginning in Australia, the RBA’s 25bp rate hike came as a surprise to ourselves and markets. Crucial to this decision was the Board’s interpretation of the Q1 CPI report, focussing on the strength of inflation amongst service components despite the moderation in the headline and trimmed mean measures seemingly running ahead of the Board’s expectations. With inflation rightly noted as being uncomfortably high, there was a greater emphasis on “the importance to returning inflation to target within a reasonable timeframe”. Note, a full update of the RBA’s forecasts was released as part of today’s May Statement on Monetary Policy.
Following the RBA’s decision, Chief Economist Bill Evans noted that, although the cash rate is currently at a level we believe will prove the peak for this cycle, the evolution of inflation and labour market outcomes represent a material risk for policy moving forward. Updated information on these indicators will be available prior to the August Board meeting. Our baseline expectation is for a further moderation in annual headline inflation (7.0% to 6.3%) and trimmed mean inflation (6.6% to 6.1%) in Q2, results which will allow the RBA to feel comfortable they are on track and allow policy to remain on hold. At the same time, the labour market is expected to remain very tight; so, should inflation not decelerate to an acceptable degree, the RBA may see cause to raise interest rates further.
Domestic data releases this week highlighted a diverging sectoral performance. Of note, nominal retail sales have only made a partial recovery so far this year, rising 0.4% in March to effectively be flat on a quarter-average basis. Given the persistence of price rises, a material contraction in inflation-adjusted sales over Q1 is likely and is therefore pointing to downside risk to household consumption as a whole, which we forecast will print an already-soft 0.3% in Q1. In contrast, the CoreLogic home value index lifted by 0.7% in April, with gains seemingly broadly-based across the nation, albeit led by Sydney where prices are up a stellar 2.7% since February. The evidence clearly indicates that the housing market’s correction phase has concluded. Meanwhile, the trade surplus surprised to the upside in March, widening $1.1bn to the second-highest surplus in the history of the series, $15.3bn.
Before moving offshore, it is worth mentioning that the Federal Budget will be released early next week. In our budget preview, we highlight that the budget position relative to October 2022 has improved materially given higher-than-anticipated commodity prices, inflation and strength in the labour market. Given the ongoing pressures facing households, there will be some flexibility to deliver targeted relief to those who are most vulnerable, but the Government is expected to show restraint by retaining the bulk of the windfall revenue gain.
To the US, the data out this week showed further evidence of an economy under pressure. The ISM manufacturing survey reported another contractionary outcome in April as production and new orders continued to decline. Employment showed resilience however, bouncing back to a marginally expansionary 50.2 after declining in February and March. Meanwhile, moderate growth continued to be seen in the service sector across both activity and employment. Of the other activity indicators released this week, construction and durable goods (a partial indicator of equipment investment) remained weak, while the JOLTS survey continued to point to a loss of momentum in new job creation without any evidence of wide-spread staff retrenchment.
Taking this information and the other data points available between the March and May FOMC meetings into consideration, the FOMC raised the fed funds rate by 25bps this week but then provided guidance consistent with a conditional pause. Notable in both the meeting decision statement and Chair Powell’s press conference was a focus on the accumulated impact of policy tightening to date and an awareness of the potential impact of recent bank closures and deposit flight on credit growth and standards. The full impact of monetary tightening and developments in the banking sector are not yet known; authorities have also made clear that regulation in the sector will be tightened hence, creating yet another headwind. For policy, the deceleration in inflation and wage pressures is therefore timely, giving the Committee another reason to be less concerned over inflation risk, and allowing more scope to consider the outlook for activity.
We remain of the view that, by December 2023, the FOMC will have enough evidence to believe that annualised inflation is back near target; with developments in the banking sector proving a persistent threat, the case to begin cutting will be proven, first by 25bps in December then by 50bps per quarter through 2024 and Q1 2025. By mid-2025, we expect a low of 2.125% to have been reached for the fed funds rate. This view is predicated on a mild recession in late-2023 and a slow recovery back to trend growth at end-2025. We view there being downside risks for activity throughout the period, while lingering upside risks for inflation should dissipate. The market is clearly more concerned over the immediate downside risks to activity, having now priced in 100bps of cuts by end-2023 and a continuation of those cuts in 2024.
In Europe, the ECB’s May meeting was the focus. While some Council members would have preferred to increase their key rates by 50bps, the consensus decision was for a 25bp rise. In contrast to the FOMC, President Lagarde made clear that the Council believe they have more to do to bring inflation back under control. While headline inflation has declined materially since its late-2022 peak, from near 11% to 7%, core price pressures have shown greater persistence, annual price growth excluding food and energy only 0.1ppts below and one month on from its peak. In recent months, both economic activity and the labour market have also shown greater resilience than was anticipated last year, giving the Council more reason to fear demand-driven inflation pressures.
The important offset to the above developments is that the latest quarterly Bank Lending Survey points to a “further substantial tightening” in standards and that “Demand for loans [has] decreased strongly”. This survey has a strong track record of guiding on the conditions faced by households and business and so, as the ECB do, should be given significant weight in assessments of the economy. All considered, it looks as though the ECB will continue their tightening cycle to mid-year then hold a tightening bias into the second half. By late in the year, the impact of policy and banking sector developments should see inflation risks abate and the case for easing develop. Cuts are still most likely to come in 2024; though the market is more concerned, with a modest probability of cuts priced in by year end. In either event, support for Euro is likely to remain in place through 2024 as policy and the balance of risks around the economic outlook favour Europe over the US.
Reversing course back to the beginning of the week, there is one further data point to discuss, China’s official NBS PMIs for April. The results of these surveys were mixed, with activity in the manufacturing sector pulling back in the month while services continued to experience robust growth. From the detail of the reports, it is clear that the weakness becoming evident in developed-world demand is impacting export orders. Further weakness has to be expected in coming months, although increasingly Asian markets and Chinese construction will have capacity to offset. Services meanwhile is likely to continue to see robust gains, with the household sector experiencing real income growth through 2022 into 2023, expansionary monetary policy (in stark contrast to the developed world), and with considerable pent-up demand to push through. A full discussion of China’s outlook relative to that of the US and Europe as well as the implications for FX markets is provided in our May Market Outlook, due for release today on Westpac IQ.