Key insights from the week that was.
In Australia, the main event this week was May’s CPI Indicator which surprised materially to the downside, headline prices falling 0.4% in the month and annual inflation decelerating to 2.1%yr, near the bottom of the RBA’s target band. The housing category was a primary source of disinflation, energy rebates continuing to supress gains in electricity prices while price discounting by project home builders saw no change in dwelling prices overall. A outsized seasonal fall for holiday travel and accommodation prices was also at play, so too a surprise fall in the cost of insurance.
As a result, on a trimmed mean basis, inflation gapped lower to 2.4%yr in May from 2.8%yr in April. While the monthly indicator is only a partial read on inflation, and the comprehensive quarterly update is still likely to show underlying inflation in the upper half of the RBA’s target band for Q2 overall, price momentum and associated risks are clearly abating.
Chief Economist Luci Ellis subsequently announced a change to Westpac Economics’ RBA rate call, with the next rate cut now expected in July instead of August. With the RBA already in the middle of a rate cutting cycle and inflationary pressure and risks receding ahead of expectations, it is becoming increasingly difficult to justify a delay.
Note though, this does not mean the RBA is ready to rapidly deliver the full cycle of cuts we and the market are forecasting to a terminal rate around 2.85%. Holding concerns over the lack of productivity growth economy wide and also remaining confident in the strength of the labour market (on display again in this week’s job vacancies data), the RBA is likely to bide their time before cutting again after the July decision. Arguably additional cuts will only be fast tracked if conditions warrant, i.e. the labour market suddenly deteriorates and/or the global outlook darkens materially, threatening Australia’s nascent recovery in consumer spending.
Before moving offshore, a note on the domestic manufacturing sector. The latest instalment of the Westpac-ACCI Survey of Industrial Trends found the gradual recovery in manufacturing conditions remains intact, the Actual Composite remaining in expansionary territory at 51.6 in Q2. Perhaps the most promising development was a surge in optimism in future conditions, evinced by the Expected Composite lifting to 59.3. This not only reflects a greater degree of confidence around the economic recovery overall but also an improving outlook for profitability, aided by easing unit cost pressures. Still, capacity constraints and the availability of skilled labour will remain significant headwinds.
Offshore, the market has primarily focused on developments in the Middle East. Thankfully, after the US’ strike at the weekend and Iran’s limited retaliation against a US military base in Qatar, a ceasefire has held between Israel and Iran. With global oil supply unaffected and negotiations to be held, the price of oil has snapped back to levels seen prior to Israel’s initial strike on Iran in mid-June, having surged circa 20% in between. While uncertainty remains elevated, the financial cost for households and businesses across the West and Asia has been negligible.
It is not surprising then that policy makers generally remain favourably disposed to the outlook, both with respect to activity growth and inflation. Chair Powell’s remarks before Congress this week were a case in point. Chair Powell believes the FOMC does not need to be in a hurry “because the economy is still strong”. Still, he believes the FOMC will start easing policy “sooner rather than later” if tariff-related inflationary pressures prove contained. The FOMC’s Bowman and Goolsbee signalled a greater degree of comfort in the inflation outlook by being open to a cut as soon as July. However, Daly, Barkin and Collins showed a preference for additional time to assess. With Chair Powell seemingly of a similar view to the latter group, a September timing for the next cut still seems most probable absent a raft of rapid trade deals that remove the tariff threat and/or a marked deterioration in the labour market in June – this report is due next Thursday, ahead of the 4th of July long weekend.
Also flagged in the second day of Chair Powell’s testimony before Congress is a proposed reduction in the enhanced supplementary leverage ratio which would lower major bank capital requirements and allow them to choose to hold more Treasuries, if they wish. Under the planned change, holding companies’ capital requirement would be lowered to 3.5-4.5% from 5% while banking subsidiaries’ requirement would be lowered to the same 3.5-4.5% range from 6% currently. A 60-day public comment period will run before the change is confirmed. If the change goes ahead, it is expected to improve liquidity and make the US Treasury market more resilient to shocks. A material reduction in yields is unlikely, however, particularly if the US budget deficit and the Federal Government’s funding needs continue to grow. Research by the Federal Reserve Bank of Boston provides context on the likely implications of the change for the Treasury market.
The data released this week has been secondary in nature and provided little clear signal. The one release to call out is the third estimate of Q1 US GDP. This is not typically a release that warrants attention. But, in this instance, it does. Leading to the headline revision from -0.2% annualised growth to -0.5% was a near two-third cut to services consumption growth in the quarter, from 1.7% annualised to just 0.6%. Services export growth was also materially revised, from -2.1% annualised to -9.7%, although this deterioration was offset by a larger downward revision to import growth. These outcomes highlight the hit to US growth from political uncertainty, particularly with respect to trade policy and migration. Services spending has been a cornerstone for US GDP growth in recent years. If weakness now takes hold, it will be difficult for the US to sustainably achieve growth at trend let alone outperform as it has done in the recent past.