Cliff Notes: Central Banks Seek a Delicate Balance

Key insights from the week that was.

Westpac-MI Consumer Sentiment was broadly unchanged in June, the modest rise from 79.0 to 79.2 reflecting a deeply pessimistic view of the outlook. The RBA’s decision to raise the cash rate by 25bps was a key factor in June, those surveyed before the decision clearly more confident (+10pts to 89.0) than those surveyed afterwards (-6.4pts to 72.6). Another foreboding development in the month centred on the labour market, an area which broadly over this cycle has been a key support for confidence. Unemployment expectations increased 6.6% to an above-average read for the first time in the cycle. With 78% of respondents after the RBA decision anticipating further rate rises, a sustained rebound in confidence faces considerable headwinds, even if household’s perceptions of job prospects don’t weaken materially from here.

The labour market certainly remains in robust health for now. Indeed, the May labour force survey delivered an upside surprise, the +75.9k surge in employment surpassing even Westpac’s near top-of-the-market forecast. It was also encouraging to see ongoing strength in the supply side of the labour market, as both the participation rate and employment-to-population ratio printed fresh record highs alongside a fall in the unemployment rate to 3.6%. This strength can, in part, be explained as a bounce-back from an unusual seasonal ‘anomaly’ in April; though, with strength across multiple indicators, if the labour market is softening, it is only doing so at the margin.

Data on Australia’s overseas arrivals and departures was also constructive for the outlook. With permanent and long-term net arrivals still tracking at an appreciable +35k/mth average pace, ongoing strength in net arrivals from students and temporary workers as well as scope for further gains from China’s reopening, the recovery in net migration remains in full swing. These gains also follow historic strength last year, the ABS’ updated population estimate confirming net migration was +387k in 2022, consistent with our long-standing view.

Before moving offshore, a quick note on businesses. The latest NAB business survey provided further evidence of an economic slowdown and a fragile, pessimistic mood amongst businesses. The business conditions index fell by 7pts to +8 in May, well down from earlier highs and reflective of the loss of momentum within the Australian economy due to high inflation and rapid interest rate rises. Against this gloomy backdrop, business confidence moderated 4pts to -4, a mildly pessimistic reading that highlights growing concern over the near-term outlook for activity.

Note, following this week’s developments for the labour market, we have revised up our peak for the RBA cash rate. We now expect a hike at the July and August meetings, taking the cash rate to 4.60%. The first rate cut is also now expected to be delayed until May 2024, previously February 2024. The implications for growth and the labour market are material, with GDP growth of just 0.6%yr and 1.0%yr forecast for 2023 and 2024, and consequently the unemployment rate seen at 5.3% by end-2024. For full detail on the forecast changes, see Chief Economist Bill Evan’s note.

There was no shortage of fanfare offshore this week, with central bank meetings, activity indicators and price data across the major regions.

In the US, the FOMC expectedly left the fed funds rate unchanged at 5.125%. The accompanying statement was broadly the same as May, but the updated member forecasts showed greater confidence in the economy and uncertainty regarding inflation. This followed the May CPI report which showed an 11th consecutive month of deceleration from June 2022’s 9.1%yr peak. Note though that annual CPI inflation is still twice the FOMC’s medium-term 2.0%yr target at 4%yr and core inflation is higher still at 5.3%yr, in large part due to shelter’s contribution.

The FOMC’s headline PCE inflation forecasts are unchanged from March at 3.2%yr, 2.5%yr and 2.1%yr 2023 through 2025; but the underlying strength of the economy saw core PCE inflation revised up 0.3ppts to 3.9%yr in 2023 and kept broadly unchanged at 2.6%yr and 2.2%yr for 2024 and 2025. That the end-2025 core PCE inflation forecast is above the 2.0%yr policy target is arguably as significant as the revision to 2023.

Consequently, FOMC members now project a year-end peak for the fed funds rate in 2023 of 5.6%, 50bps higher than March. The end-2024 and 2025 forecasts are also 30bps higher than the prior set, respectively 4.6% and 3.4%. Versus the ‘longer-run’ estimate of 2.5%, this implies Committee members believe it will prove necessary to keep policy restrictive for more than 2.5 years from today.

On balance, the FOMC’s June decision leads us to believe one more 25bp hike in July is the most likely course – come early-2024 we expect the case to have been made for rate cuts.

Elsewhere in the US, retail sales surprised to the upside rising 0.3%mth in May supported by an uptick in building materials and gardening equipment. Stripping away volatile components, retail sales rose 0.2%mth versus 0.5%mth in April, indicating discretionary spending is being tempered. Initial jobless claims held up at their highest level since 2021 last week; however, claims are still near their historic low.

Over in Europe, the ECB lifted rates by 25bps as underlying inflation remained strong. While the statement acknowledged inflation has decelerated, updated projections point to inflation remaining sticky. Underlying inflation is expected to reach 5.1%yr in 2023 (previously 4.6%yr), 3%yr in 2024 (previously 2.9%yr) and then come down to 2.3%yr by 2025 (previously 2.1%yr). These forecast compare to May’s 5.3%yr read. Given the upgraded inflation outlook, it was no surprise that President Lagarde characterised a July rate hike as ‘very likely’ at the press conference. Views on the meetings beyond were relatively non-committal, with the Governing Council intent on remaining data dependent.

Coming back to Asia, China’s May data came in weaker than April, which also was a downside surprise. Fixed asset investment nudged down to 4.0%yr year-to-date as a result of slower growth in state-owned projects and a small decline in private investment. The slowdown in investment will be of concern to policymakers whose growth and social ambitions rely on capacity and income expansion into the medium term.

Unsurprisingly, the PBoC cut the 7-day reverse repo rate by 10 basis points, and followed up with a cut in the medium-term lending rate. But for firms and the consumer, there is need for additional support. On consumption, retail sales growth slowed in May to 12.7%yr from the 18.4%yr seen in April. Services spending continues to outpace goods coming out of lockdown. Highlighting the impact of decelerating developed-world demand, industrial production was lacklustre, growing 3.5%yr, or 3.6%yr year-to-date. Out of the 16 categories, 13 reported increases in year-to-date terms. Of particular note, the production of electric vehicles has ramped up substantially compared to a year ago.