Key insights from the week that was.
The Australian Q2 CPI report provided a constructive update on inflation, highlighting a broad-based moderation in the pace of price increases across the consumption basket. The main results were a 0.8% (6.0%yr) lift in headline inflation and a 0.9% (5.9%yr) rise in trimmed mean inflation, both of which were below the market’s expectation and our own. Highlighting the extent of the underlying moderation, the six-month annualised pace of core inflation has fallen from 6.0%yr to 4.3%yr, driven not only by a slowing in goods inflation but also services, including household services such as childcare as well as medical and hospital services. This is a welcome development for the RBA, with the easing in both headline and underlying inflation now running ahead of their forecasts from May.
In light of this update, as discussed by Chief Economist Bill Evan, we have lowered our forecast for the peak in the cash rate from 4.60% to 4.35%. That said, the persistence of services inflation and historically-tight labour market still present clear upside risks to the inflation outlook, concerns which Governor Lowe has consistently emphasised in recent months. In our view, this warrants additional insurance to be taken in the form of one further 25bp rate hike next week. A tightening bias is also likely to remain in place in coming months as the Board continue to assess the pace and breadth of disinflation across the services sector as well as the labour market’s strength.
Offshore, the US FOMC and European Central Bank (ECB) both raised their policy rates by 25bps at their July meeting as expected. In the press conference, FOMC Chair Powell made clear that the Committee will be closely scrutinising the strength and capacity of the economy in the months ahead, with subsequent decisions ‘data dependent’. Notably, between the July and September meetings, two CPI reports and two employment reports are due, giving the Committee clarity on whether June’s below-expectations CPI is a sign of the emergence of broad-based and sustainable disinflation or just a one-off reading. The former requires a further deceleration in employment and spending into 2024, and for inflation expectations to remain well anchored.
While the Q2 advanced GDP estimate came in at an above-trend 0.6%qtr, 2.6%yr annualised, the component detail was consistent with a disinflationary outlook. Services consumption slowed to a near-trend pace and growth in goods consumption was negligible in the quarter. Business investment meanwhile surprised to the upside as equipment spending surged following a protracted period of weakness and non-residential construction continued to grow strongly. Note the investment outcomes are not a concern for inflation on their own; to the contrary, greater capacity and efficiency will aid the fight against inflation. Housing investment remains a source of concern though, with activity continuing to contract at a time when additional supply is necessary. Also worthy of note is that both the consumer and aggregate GDP deflator came in below expectations, the GDP deflator noticeably so. This result may be the result of dissipating supply frictions, but it could also be statistical – a point to watch as revisions are received.
Looking ahead, the latter part of Q2 experienced a loss of momentum and further tightening in credit conditions, pointing to a materially weaker pace of growth through the second half and into 2024. Constructively though, Chair Powell’s forward guidance on 2024 and beyond went as far as to envision a need to ‘stop raising long before you got to 2% inflation and… start cutting before you got to 2% inflation too’. He also went on to signal an eventual return to neutral or expansionary monetary policy. We view these comments as broadly in line with our current forecasts for a first rate cut in March 2024 and significant easing thereafter through 2024 and 2025 to a fed funds rate of 2.625%. You can read our full analysis on the FOMC’s decision and US outlook here.
Mirroring the US FOMC’s decision, the ECB also raised their three policy rates by 25bps as widely expected, though the statement carried a more doveish tone. President Christine Lagarde signalled that little forward guidance would be given from here, with future rate hikes data-dependent. Lagarde expanded upon the change of verb describing the path of interest rates from ‘the key ECB interest rates will be brought to levels sufficiently restrictive to achieve a timely return of inflation’ to ‘set to’. She explained this change of verb was deliberate and the two inflation readings alongside indicators of policy transmission would guide the decision in September. Additionally, the ECB announced it would cease remuneration for minimum reserves to make monetary policy transmission more ‘efficient’.
The ECB’s projections suggest inflation is expected to average 5.4% in 2023, while growth thus far would put inflation at 4.9%yr in 2023. In addition to a weaker inflation print, the second quarter Bank Lending Survey released this week, showed that credit standards had tightened for enterprises and house purchases. Demand for credit has also fallen further for enterprises, though the net percentage of banks reporting an increase in home loan demand had become less negative. The latter was a result of less pessimistic housing market prospects.
Should data continue to come in mild, further rate hikes may not be needed. However, much like the RBA, a tight labour market and momentum in services inflation could justify the ECB take additional precautions in coming months.