Cliff Notes: Inflation Remains the Market’s Chief Concern

Key insights from the week that was.

This week, the RBA Board opted to raise the cash rate by 25bps to 4.35%. As detailed by Chief Economist Luci Ellis, this decision marked a direct response to persistence in inflation and upside risks to the outlook. The underlying tone of the real economy has shifted in recent months, the household sector exhibiting resilience against intense interest rate and cost-of-living pressures. This has, in part, contributed to the more worrisome inflation outlook, with the Board noting that “the prices of many services are continuing to rise briskly” and, regarding inflation’s return to target, that “progress looks to be slower than earlier expected”. Indeed, the RBA Board have revised up their inflation projections – from 3.3% to 3.5% in 2024 and 2.8% to 2.9% in 2025 – and now expect a firmer labour market, with the unemployment rate expected to rise to just 4.3% (previously 4.5%). A full update of the RBA’s forecasts and assessment of risks is available in the just released November Statement on Monetary Policy.

On the outlook for policy, we are of the view that the RBA Board will not raise rates further from here. If the real economy continues to evolve as we anticipate, i.e. economic growth remains well below-trend and slack emerges in the labour market, inflation should continue to decelerate at pace. That will give the RBA Board confidence that policy is working as intended, shifting the focus towards when it is most appropriate to begin easing policy, which we anticipate will be in Q3 2024. However, if there were to be further material upside surprises to the inflation outlook in the near-term – something that the RBA Board clearly has a low tolerance for – the risk of another interest rate increase is not dismissible. For more information on our views on the Australian economy and global outlook, see the November edition of Westpac’s Market Outlook on Westpac IQ.

Moving offshore, Chinese annual CPI inflation fell back below zero in October to -0.2%yr as a result of deflation in food prices. Upward pressure on the CPI came from services where momentum has been accelerating the last few months. Consistent with the 2.6%yr decline in the PPI, the decline in consumer goods also endured. The potential impact of persistent weak inflation on the consumer mindset is likely being assessed by PBOC policymakers. Market participants expect a further 10bp reduction in the 1-year loan prime rate and 25bp cut in the Reserve Requirement Ratio in the near future. However, with the property sector outlook still highly uncertain, it will take a lot more stimulus for consumer demand to grow strongly on a sustainable basis.

Overnight, FOMC Chair Powell spoke at an IMF Panel on monetary policy. His remarks were balanced, recognising the significant progress made in the fight against inflation but also that 2% is still a long way away and that risks remain, and so if “it becomes appropriate to tighten policy further, we will not hesitate to do so”. However, the “risk of overtightening” is also front of mind for the FOMC, particularly as the full effects of the tightening in monetary policy and financial conditions are yet to be felt. This was a point highlighted by the FOMC’s Barkin this week and the latest Senior Loan Officers Survey which showed a further tightening of loan conditions and increased credit spreads. We expect both US economic activity and the labour market to soften in coming months; if inflation also continues to ease over the period, then the FOMC will have cause to ease from March to stop a further tightening in the real stance of policy. Financial conditions will also prove critical to this decision making process, however. If term yields fall further, the market could be argued to have done the FOMC’s easing for it.

Chair Powell’s speech is also interesting for its views on the potential implications for inflation of supply shocks and constraints. These are forces that threaten to hold inflation above target even with growth at or below trend. Balancing the risks between inflation and growth is set to remain a concern not only for the next few months, but into the medium term.