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Sydney – 6 September 2022

Members present

Philip Lowe (Governor and Chair), Mark Barnaba AM, Wendy Craik AM, Ian Harper AO, Carolyn Hewson AO, Steven Kennedy PSM, Carol Schwartz AO, Alison Watkins AM

Members had granted leave of absence to Michele Bullock (Deputy Governor), in accordance with section 18A of the Reserve Bank Act 1959.

Others present

Luci Ellis (Assistant Governor, Economic), Christopher Kent (Assistant Governor, Financial Markets), Andrea Brischetto (Head, Financial Stability Department)

Anthony Dickman (Secretary), David Jacobs (Deputy Secretary)

Marion Kohler (Head, Economic Analysis Department), Penelope Smith (Head, International Department), Carl Schwartz (Acting Head, Domestic Markets Department)

International economic developments

Members commenced their discussion by noting that global inflation was high and well above central banks' targets in many economies. High inflation was impinging on households' real incomes and sentiment, and the rapid increase in interest rates would further weigh on aggregate household disposable income. Fuel prices had declined recently and the latest data showed headline inflation had stopped rising in most economies, with the exception of Europe. However, underlying inflation remained high, so it was too early to conclude that this represented a change in trend. Upstream price pressures had continued to moderate, and supplier delivery times had edged closer to levels last seen prior to the pandemic. Shipping rates had also fallen over recent months. On the other hand, services inflation was still rising and wages growth in some economies was faster than would be compatible with inflation returning to targets.

Members observed that analysts had again downgraded the outlook for global growth, reflecting the deteriorating outlook in Europe and for interest-rate sensitive sectors in a number of economies. While some forward-looking business surveys had turned down in the past month or so, recent data in many economies pointed to ongoing expansion. Domestic final demand in advanced economies had remained firm in the June quarter, supported by an increase in consumption of services. Strong growth in nominal labour incomes and, in some advanced economies, further declines in saving rates were cushioning the effect of higher inflation on households' spending. Labour markets remained strong, with job vacancies exceeding the number of unemployed in many cases. While business hiring intentions were slightly below their peaks, they remained at a very high level.

Energy availability had become a critical issue in Europe. Members noted that reduced gas supplies from Russia had coincided with a severe drought and other disruptions to production that had reduced the availability of hydro and nuclear power. European gas prices had surpassed their March peaks as Russian supplies to Europe had fallen 80 per cent below 2021 levels. The price of wholesale electricity was at record highs across the continent and was expected to remain at very high levels for the foreseeable future. Household and business energy costs were expected to surge later in the year as recent increases in wholesale gas prices are passed on to retail bills. Gas consumption had fallen significantly and authorities had committed to restrict consumption to 15 per cent below normal levels through winter.

The Chinese economy was recovering from recent lockdowns, but was facing significant headwinds, especially in the real estate sector. Policy remained accommodative and fiscal support had increased recently, with infrastructure investment expected to be a key driver of growth this year. Industrial production had increased moderately in July, although there had been some disruptions in a couple of provinces stemming from drought and associated electricity shortages. Members observed that the Chinese real estate sector remained very weak, despite some recent policy support. New housing sales had declined in July to be back around their lows during recent lockdowns. Liaison contacts had reported that market confidence had been affected by concerns about the solvency of developers. The weak outcomes for residential construction were exacerbating the outlook for steel production, which had already been constrained by government production caps. Iron ore prices had declined towards the bottom of their range over the past two years.

Members noted that high coal and gas prices were supporting Australia's terms of trade at record levels. In contrast to other energy commodities, crude oil prices were well below their peaks following Russia's invasion of Ukraine. This decline reflected concerns about the global outlook and improved supply. Even so, the price of crude oil remained about 20 per cent above the level at the beginning of 2022. Limited spare capacity and gas-to-oil substitution in Europe and elsewhere were likely to support crude oil prices in the period ahead. Base metals and food commodity prices had been fairly steady over the preceding month, but had declined from the peaks reached after Russia's invasion of Ukraine.

Domestic economic developments

Turning to the domestic economy, members observed that timely indicators pointed to inflation remaining high and broadly based in the September quarter. Some retailers expected to apply further large increases in their prices in coming quarters, in part reflecting the pass-through of earlier rises in input costs. By contrast, petrol prices had declined in August and were expected to subtract from headline inflation in the September quarter. The expiration of the fuel excise cut would boost headline inflation in the December quarter. Consistent with the decline in petrol prices, short-term measures of inflation expectations had declined modestly. Longer term inflation expectations generally remained within the inflation target range. Members noted that, from October, the Australian Bureau of Statistics would commence publishing a monthly CPI indicator, which would provide a timelier read on price pressures – though it could take some time for reliable trends to be discernible.

Household spending appeared to have held up in the September quarter to date. Strong labour market conditions and income growth were providing an important counterbalance for household budgets that faced increased pressure from rising prices and higher interest rates. Although payments data had softened a little of late, retail sales had increased strongly in July and most retailers in the Bank's liaison program had indicated that consumption behaviour was changing only slowly in response to cost-of-living pressures. Spending overseas by Australian residents had also grown strongly over prior months, which – although it would not add to domestic demand – was consistent with the ongoing rebalancing towards pre-pandemic patterns of spending. Members noted that domestic activity would benefit from increased numbers of foreign tourists and students, which are recorded as services exports.

Declines in housing prices had broadened out to most capital cities and regional areas, alongside weaker housing sales activity, rising interest rates and the expectation of further interest rate increases. By contrast, rental markets were tight. Vacancy rates in Sydney and Melbourne had declined from the high levels seen since the start of the year and were likely to decline further as international student numbers increased. Vacancy rates in other capital cities remained around historical lows.

Members noted that the June quarter National Accounts would be released the day after the meeting. GDP was expected to have grown strongly in the quarter, with growth in domestic final demand led by household consumption. Residential construction work done was expected to have declined in the June quarter, reflecting wetter-than-average weather conditions along the east coast of Australia, as well as ongoing shortages of materials and labour. Exports had grown strongly in the quarter, underpinned by resources exports, following several soft outcomes.

The outlook for business investment remained positive. The June quarter ABS Capital Expenditure Survey, conducted in July and August, indicated that non-mining firms expected to increase investment in the 2022/23 financial year, driven by investment in machinery and equipment. Capacity utilisation remained high across industries, with non-mining capacity utilisation at its highest level in over three decades.

The demand for labour remained robust, judging by the timely information from job ads and liaison. Most firms in the liaison program expected to increase headcount, but some had expressed concern about their ability to do so because of poor labour availability and strong competition from other firms. Measured employment had declined in July; however, looking through the monthly volatility, the labour market remained very strong. The employment-to-population ratio and participation rate were around record highs, and measures of spare capacity were at their lowest levels in decades. The unemployment rate had declined further to 3.4 per cent in July. Members noted recent announcements that staffing levels in visa processing would be increased to clear backlogs in this area. Immigration of skilled workers, students and working holidaymakers could all be anticipated to increase in the period ahead, which would add to labour supply as well as aggregate demand.

Wages growth was picking up as expected. A range of timely measures, including from liaison, business surveys and measures based on retail banking data, indicated that this pick-up had continued over prior months. In the June quarter, the Wage Price Index had increased by 0.7 per cent in the quarter and 2.6 per cent in year-ended terms. The pick-up in growth had been stronger in the private sector than in the public sector, where wages growth had remained more subdued. Wages growth had been strongest in the construction industry, consistent with information from liaison about labour costs and availability in that industry.

International financial markets

Members commenced their discussion of international financial markets by noting that central banks in most advanced economies had been increasing policy rates at a rapid pace to address high inflation and mitigate the risk that above-target inflation becomes embedded in wage- and price-setting behaviour. During the preceding month, the Bank of England, the Norges Bank and the Reserve Bank of New Zealand had raised their policy rates by 50 basis points, and the Bank of Korea had increased its policy rate by 25 basis points.

Central banks in most advanced economies had continued to signal that further policy rate increases are likely. Communication from the Federal Reserve and the European Central Bank emphasised that inflation is likely to be more persistent than earlier expected and that policy rates will need to remain higher for longer in order to bring inflation back to target. At the same time, these central banks acknowledged the adverse effect such outcomes would have on economic activity.

Government bond yields had risen over the preceding month, reflecting upward revisions to the policy rate paths implied by market pricing as well as increases in inflation expectations for the near term. Members noted that longer term inflation expectations had also increased, but remained within the 2 to 3 per cent range in most advanced economies. Sovereign yield curves in a number of advanced economies – including Canada, the United Kingdom and the United States – were flat or downward sloping, indicating market concerns about the possibility of recessions in these economies. Members observed that the Australian yield curve remained upward sloping.

Private sector financing conditions had become tighter than earlier in the year. Equity prices had fallen noticeably and corporate bond spreads were higher as market participants' expectations for policy rates had trended higher. The US dollar had appreciated further, consistent with another increase in short-term US Government bond yields relative to other economies.

The Australian dollar had depreciated against the US dollar over the year to date, but had appreciated on a trade-weighted basis over the same period. The RBA Index of Commodity Prices was around its levels at the beginning of the year, despite the decline in the price of iron ore.

The People's Bank of China had eased monetary policy further amid signs of increased weakness in the Chinese economy, particularly in the property sector; authorities had also announced lending support to help complete unfinished apartment projects. The further easing of policy rates had been associated with downward pressure on the renminbi, which had depreciated further from its recent lows against the US dollar as the interest rate differential between US and Chinese government bonds had widened.

Domestic financial markets

Members noted that, in the domestic market, yields had increased over the preceding month in line with global developments. Members observed that market pricing implied the cash rate was expected to be increased by a further 50 basis points in September, and to be around 3¼ per cent by the end of the year. The end-year pricing was a little above the median forecast of market economists. Banks' overall funding costs had increased significantly in recent months, as much of their wholesale funding is ultimately linked to money market rates. Retail deposit rates had also increased, but by a smaller amount.

As was the case in previous months, housing lenders had passed on the full amount of the increase in the cash rate in August to their standard variable rates. Members noted that, as the previous increases in the cash rate flowed through, mortgage interest payments were expected to increase to around 4½ per cent of household disposable income over the coming months, and to almost 5 per cent by the end of the year. These estimates assumed that maturing fixed rate loans would be replaced with variable rate loans. Overall interest payments on housing loans were expected to respond more gradually to changes in interest rates than in the past because of the higher fixed-rate share of credit (almost 35 per cent of housing credit at present, compared with 20 per cent prior to the onset of the pandemic). Net payments into offset and redraw accounts had remained strong up to July, in line with flows in 2021, despite the rise in interest payments.

Members observed that credit growth had remained strong overall. Demand for business credit had been supported in recent months by strong economic conditions and the lagged effects of a high level of mergers and acquisitions activity. In addition, bank credit had been favourably priced relative to the issuance of corporate bonds, and businesses had drawn down existing credit facilities to manage liquidity challenges arising from supply chain disruptions and cost increases. By contrast, housing credit growth had moderated in recent months, and the decline in housing loan commitments from their high level at the start of the year was expected to result in a further slowing in housing credit growth in the period ahead.

Review of the bond purchase program

Members reviewed the operation and effectiveness of the bond purchase program (BPP) introduced in November 2020 as part of the second package of monetary policy measures implemented by the Bank in response to the effects of the COVID-19 pandemic. The discussion was based on a staff review commissioned by the Board.

Members observed that the BPP, together with the other monetary policy measures put in place during the pandemic, had contributed to the strong recovery of the Australian economy, with unemployment having declined to its lowest rate in almost 50 years.

The BPP involved purchasing government bonds in order to lower yields at the 5–10 year part of the yield curve. The program was introduced to complement the price-based, three-year yield target introduced in March 2020 and the Term Funding Facility, along with the longstanding overnight cash rate target, which forms the anchor point for the risk-free interest rate term structure. Together, the policy measures had lowered the whole structure of interest rates in Australia and supported confidence in the economy. However, members noted that it is difficult to identify the exact effect of the BPP on the economy, because it was implemented as part of a broader package of policy measures that reinforced one another. Moreover, a key benefit of the policy package was to provide insurance against the significant downside risks the economy was facing during the pandemic – a benefit that is inherently very difficult to quantify, especially given that downside risks were avoided.

Members noted that the BPP had affected the public sector balance sheet in several ways. There is expected to be a financial cost to the Bank because the purchased bonds pay a fixed return, while the interest paid on the Exchange Settlement (ES) balances created to finance the bonds varies with monetary policy settings and so rises as monetary policy is tightened. The ultimate cost will be known only once the last of the purchased bonds matures in 2033. Members noted that it is important to assess this potential cost in the context of the wider benefits to the economy that have flowed from the BPP as part of the package of monetary policy measures. There are also expected to be a number of benefits to the public sector balance sheet. The reduction in yields lowered the cost of government debt issuance, while stronger economic activity than otherwise increased tax revenues and reduced government support payments. These benefits to government finances are material, although they are difficult to quantify. Members observed that the Bank would record an accounting loss in 2021/22 because the increase in bond yields (consistent with the higher expected path of the ES rate) had caused the market value of the purchased bonds to fall. At the same time, the overall Commonwealth financial position would incorporate some offsetting accounting gains, given issued bonds represent a liability on the general government balance sheet.

In light of the experience, members judged it appropriate to consider use of a BPP again only in extreme circumstances, when the usual monetary policy tool – the cash rate target – has been employed to the full extent possible. Compared with a yield target, a BPP provides more flexibility to respond to evolving economic circumstances, although it could entail larger financial costs. In considering any future use of a BPP, members noted that it would need to be evaluated against other policy options at the time, taking into account the costs of the BPP under a full range of scenarios.

Members agreed to the publication of the review of the BPP. A review of the Bank's approach to forward guidance is under way and will be published later in the year.

Considerations for monetary policy

In considering the policy decision, members noted that inflation in Australia was at its highest level in several decades and was expected to increase further over the months ahead. Global factors continued to explain much of the increase in inflation. However, domestic factors were also playing a role, with widespread upward pressure on prices from strong demand, a tight labour market and capacity constraints in some sectors of the economy.

Members noted that inflation was expected to peak later this year and then decline back towards the 2 to 3 per cent target range. The expected moderation in inflation reflected the ongoing resolution of global supply-side problems, recent declines in some commodity prices and the impact of rising interest rates. Medium-term inflation expectations remained well anchored, and it was seen as important that this remain the case. The Bank's central forecast was for CPI inflation to be around 7¾ per cent over 2022, a little above 4 per cent over 2023 and around 3 per cent over 2024.

The Australian economy was continuing to grow solidly. Consumer spending had so far been resilient to higher interest rates, and national income had been boosted by a record level of the terms of trade. At the same time, the increases in interest rates had seen an easing of conditions in the established housing market alongside a softening in household demand for credit.

The labour market had remained tight and continued to indicate that the economy was having difficulty meeting the level of aggregate demand. Many firms were finding it challenging to hire workers. The unemployment rate had declined further in July to 3.4 per cent, the lowest rate in almost 50 years, and the continued high level of job vacancies suggested a further decline was in prospect over the months ahead. Members noted that many Australians are benefitting from the greater opportunities for work provided by the tighter labour market, notably young people, women and longer term unemployed people. Beyond the near term, some increase in unemployment was expected as economic growth slows owing to the effects of higher interest rates, although members noted that changes in labour market conditions tended to lag some other indicators of economic activity.

Wages growth had picked up from the low rates of prior years and there were some pockets where labour costs were increasing briskly. However, members noted that the rate of base wages growth so far had not reached levels that would be inconsistent with achieving the inflation target on a sustained basis. Nevertheless, given the tight labour market and the upstream price pressures, the Board would continue to pay close attention to both the evolution of labour costs and the price-setting behaviour of firms in the period ahead.

Members noted that an important source of uncertainty continued to be the behaviour of household spending. Higher inflation and higher interest rates were putting pressure on household budgets. Consumer confidence had also fallen and housing prices were declining in most cities and regions after the earlier large increases. Working in the other direction, people were finding jobs, gaining more hours of work and receiving higher wages. Many households had built up large financial buffers and the saving rate remained higher than before the pandemic. While the high levels of payments into offset and redraw accounts suggested that some households remained in a favourable financial position, members acknowledged that other households were finding conditions difficult in the face of higher interest rates and higher inflation. The Board would be paying close attention to how these various factors balanced out as it assessed the appropriate setting of monetary policy.

The outlook for global economic growth had deteriorated and posed a key uncertainty. Central banks in several large advanced economies had expressed further resolve in tightening monetary policy to prevent high inflation from becoming entrenched, and this was likely to entail a period of significantly lower growth. High inflation was also placing pressure on real incomes, most significantly in Europe, related to the worsening effects on energy markets following Russia's invasion of Ukraine. In addition, COVID-19 containment measures and other policy challenges continued to weigh on the outlook for growth in China. Some slowing in the global economy would be important to returning inflation to central banks' targets, but the potential for a sharp slowing continued to present a downside risk to the outlook.

Members judged that a further increase in interest rates would help bring inflation back to target and create a more sustainable balance of demand and supply in the Australian economy. They discussed the arguments around raising interest rates by either 25 basis points or 50 basis points. Members emphasised that price stability is a prerequisite for a strong economy and a sustained period of full employment. They acknowledged that monetary policy operates with a lag and that interest rates had been increased quite quickly and were getting closer to normal settings. Given the importance of returning inflation to target, the potential damage to the economy from persistent high inflation and the still relatively low level of the cash rate, the Board decided to increase the cash rate by a further 50 basis points.

The Board expects to increase interest rates further over the months ahead, but it is not on a pre-set path given the uncertainties surrounding the outlook for inflation and growth. The full effects of higher interest rates were yet to be felt in mortgage payments, and the broader effects on activity and inflation would take some time to be apparent. The Board was resolute in the need to ensure inflation returned to target, but mindful that the path to achieve this needed to account for the risks to growth and employment. The Board is seeking to return inflation to target while keeping the economy on an even keel. The path to achieving this balance remains a narrow one and clouded in uncertainty.

The size and timing of future interest rate increases will continue to be guided by the incoming data and the Board's assessment of the outlook for inflation and the labour market, including the risks to the outlook. All else equal, members saw the case for a slower pace of increase in interest rates as becoming stronger as the level of the cash rate rises. The Board is committed to doing what is necessary to ensure that inflation in Australia returns to target over time.

The decision

The Board decided to increase the cash rate target by 50 basis points to 2.35 per cent. It also increased the interest rate on Exchange Settlement balances by 50 basis points to 2.25 per cent.

Japan CPI accelerated from 2.6% yoy to 3.0% yoy in August, above expectation of 2.6% yoy. CPI core (ex-fresh food), rose from 2.4% yoy to 2.8% yoy, above expectation of 2.7% yoy. CPI core-core (ex-fresh food, energy), also rose from 1.2% yoy to 1.6% yoy, but missed expectation of 1.7% yoy.

CPI core, the BoJ watched reading, hit the highest level in 31 years since 1991, excluding the effect of sales tax hike. Even including the impact of sales tax, the reading was still the highest in nearly 8 years.

BoJ is widely expected to continue to stand pat, and maintain negative interest rate later this week. But there are expectations that core inflation could hit 3% later in the year, and stay above the 2% target in the near term. That might start to change BoJ's view on prices and policy at a later stage.

Full release here.

Key Highlights

• GBP/USD traded to a new 37-year low at 1.1350.
• It traded below a connecting bullish trend line with support at 1.1495 on the 4-hours chart.
• EUR/USD is consolidating losses below the 1.0050 resistance zone.
• Gold price declined and traded below the $1,670 level.

GBP/USD Technical Analysis

The British Pound started a fresh decline from the 1.1720 zone against the US Dollar. GBP/USD gained bearish momentum below the 1.1650 and 1.1580 levels.

Looking at the 4-hours chart, the pair extended losses below the 1.1500 support, the 100 simple moving average (red, 4-hours), and the 200 simple moving average (green, 4-hours).

The bears gained strength and pushed the pair below the 1.1400 support. GBP/USD traded to a new 37-year low at 1.1350. It is now consolidating losses and facing resistance near the 1.1450 level. The first major resistance is near the 1.1485 level.

The next major resistance might be 1.1550 and the 100 simple moving average (red, 4-hours). A clear move above the 1.1550 and 1.1560 levels could open the doors for a larger increase. In the stated case, the pair might rise towards the 1.1650 and 1.1720 levels.

On the downside, an initial support is near the 1.1350 level. A downside break below the 1.1350 support might send the pair towards the 1.1280 level.

The next major support is near the 1.1200 level, below which the pair could even test the 1.1000 level in the coming days.

Looking at gold price, the bears seem to be active below the $1,680 level and there is a risk of a move below the $1,650 support zone.

Economic Releases

• US Housing Starts for August 2022 (MoM) – Forecast 1.445M, versus 1.446M previous.
• US Building Permits for August 2022 (MoM) – Forecast 1.610M, versus 1.685M previous.
• Canadian Consumer Price Index for August 2022 (MoM) – Forecast -0.1%, versus +0.1% previous.
• Canadian Consumer Price Index for August 2022 (YoY) – Forecast +7.3%, versus +7.6% previous.

We have long argued that the Reserve Bank Board should slow the pace of rate increases once it reaches its assessment of neutral. That is particularly because of the 'treacherous lags' that will have built up as the inevitable result of such a sharp rate increase in rates, from 0.1% back in May.

The Governor has certainly indicated that intention, both in the speech to the Australian Business Economists on September 8 and in the Parliamentary hearing last Friday.

Our view had been that the scaling back to a slower pace of tightening could begin from the October meeting, with the cash rate having reached the 'neutral zone' at 2.35%.

However there has always been some uncertainty as to whether a starting point of 2.35% would be too far below the Governor's assessment of neutral.

We know that he has argued in the past that the 'real' neutral is at least zero, implying a 2.5% nominal rate given longer term inflation expectations. That is above the 2.35% starting point for the October meeting.

Whether he wants to start the scale-back at a rate below his assessment of neutral or begin when rates are much nearer his estimate of neutral will be influenced by his assessment of the risks on inflation, the labour market and the economy in general.

There were significant remarks in the Parliamentary hearing on Friday that suggest he will err on the side of a higher rate before deciding to scale back the pace of tightening.

We now expect the Governor to decide to push the rate more clearly into his best estimate of the contractionary zone before scaling back the pace of increases.

That suggests that he will push the rate to 2.85% with a 50bp increase at the October Board meeting.

Some comments at the House of Representatives Standing Committee on Economics hearing that resonated were:

On the risks:

• "… the general inflation psychology appears to be shifting; it is easier for firms to put their prices up, and the public is more accepting of this."
• "… it is important that we avoid a cycle where higher inflation leads to higher wages and inflation running high."
• Comment: he seems very unnerved about the risks of inflationary expectations getting away from him.

On the language:

• "We're CLOSER to a normal setting now, which means the case for large adjustments has diminished."
• "… AT SOME POINT we'll obviously not need to be increasing rates by 50 basis points at each meeting, and we're GETTING CLOSER to that point.
• "… we're getting to that range that you'd think is normal but probably still on the low side."
• Comment: we are getting CLOSER but we are not there yet.

On the economy:

• "… recent data suggests that spending has remained resilient so far."
• "… it's incredibly difficult to hire workers."
• "… retail spending was again pretty firm."
• "… spending in the economy is pretty strong."
• Comment: chose to emphasise his assessment that the economy remains strong

Those comments on the timing of the point at which the Board moves to a slower pace appear to be more cautious than we saw from the Governor's Statement following the September Board meeting.

This could be significantly explained by the events in global markets following the US inflation report released on September 13.

As a result of that report and the hawkish language from Fed Chair Powell at Jackson Hole, we lifted our forecast for the terminal federal funds rate from 3.375% to 4.125%, including a 75bp move at the September 20-21 FOMC meeting.

While the Governor makes the point consistently that the Fed has a more urgent inflation challenge than the RBA due to much faster wage growth, he will take notice of such a sharp reassessment of the outlook for US interest rates and interest rates globally.

That relates to not only the near-term outlook but the assessment of higher global rates in general.

As such we have also raised the terminal rate from 3.35% to 3.6%.

Raising the terminal rate by 25bps compared to the 75bp increase in the federal funds rate still acknowledges Australia's higher sensitivity to the central bank's policy instrument.

Recall that the key reason why the RBA reluctantly adopted QE in 2020 was maintaining competitiveness in the AUD. The Governor would be concerned that such a sharp widening of the expected yield differential with global rates will have implications for a weaker AUD complicating the inflation challenge.

We have not changed our post October profile with increments shifting down to 25bp as emphasised in the comments above.

Having comfortably exceeded the neutral target it seems likely that he would then deliver on the guidance to slow the pace.

But unlike most analysts we continue to expect that the tightening cycle will continue for November, December and February.

The November and February increases will be in response to ongoing evidence of sustained inflation pressures in the September and December inflation reports.

Clear evidence of the expected slowdown in inflation will not be apparent until late February, allowing the RBA to go on hold in March on evidence that growth is slowing and that inflation and rates have also peaked in the US.

We have already sharply marked down own our growth forecast for 2022 to 1%, to incorporate the previous terminal rate forecast of 3.35%.

That 1% growth rate (and the associated 1.2 ppt increase in the unemployment rate in 2023) now has some downside risks but, for now, given the current momentum in the economy we have decided not to mark 2023 growth down any further.

We also note that since we forecast the 1% growth rate in 2023 we have revised down our 2022 growth rate from 4.4% to 3.4% meaning that the level of GDP by end 2023 will be considerably lower than we had expected when we first made the 1% growth forecast.

Readers may see that 3.6% terminal rate as 'over-tightening' but our view is that the growth rate required to achieve the objective of wringing inflation out of the system is consistent with the 3.6%.

Given these extreme circumstances around the build up of inflationary pressures central banks will take the policy of 'least regret'. Which will be to err on the side of containing inflation at the potential cost of growth in the near term.

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We have a very busy week ahead of us with four central bank meetings on the agenda, but the one to stand out may be the FOMC decision, scheduled on Wednesday at 18:00 GMT. Following last week’s hotter-than-expected CPIs for August, market participants have put on the table a full percentage point hike. But will the Fed really step on the brakes harder this time around, and how will the outcome affect the dollar?

How did investors get to the 100bps bet?

At its latest meeting in July, the FOMC delivered its second consecutive 75pbs hike, but Fed Chair Powell said that it may become appropriate to slow the pace of future increases, painting a picture that stood far from today’s reality. The Committee did not meet in August, but investors had the opportunity to hear again from the Fed chief at the Jackson Hole economic symposium. There, Powell appeared in his hawkish suit, saying that they will raise interest rates as high as needed and keep them there “for some time”. While he acknowledged that this could hurt economic growth as well as labor market conditions, he added that these are the “unfortunate costs of reducing inflation,” and since then, many of his colleagues agreed, with Cleveland Fed President Loretta Mester adding that interest rates should rise to slightly above 4%.

All this encouraged market participants to add to their bets over a more forceful Fed, but the icing on the cake was last week’s hotter-than-expected CPI data, which disappointed those expecting inflationary pressures to ease in the months to come and allowed others to place bets over a full percentage point rate increase at this gathering. According to the Fed funds futures, market participants are now assigning a 20% chance for such an action, with the remaining 80% pointing to a 75bps increase. This may have increased the risk of disappointment and thereby the chances for a setback in the dollar, even in the still very hawkish case of a third 75bps hike.

New ‘dot plot’ to determine the dollar’s faith

Yet, a trend reversal in the dollar’s prevailing uptrend remains very doubtful. Wednesday’s decision will be accompanied by updated economic projections and a new ‘dot plot’. Thus, investors’ choices will largely depend on that as well. Currently, market participants agree that interest rates could rise above 4%, expecting a peak at around 4.4% in March, but they oppose the assessment that they should stay there for some time. They are pricing in a 25bps reduction by September. For that reason, a new plot pointing to a peak near 4.4%, but no cuts for the remainder of the year – in line with many officials’ recent remarks– could add fuel to the dollar’s engines and allow it to claw back any hike-related losses.

Euro/dollar could jump slightly higher in case the Fed hikes by 75bps, but a hawkish narrative and a dot plot pointing to no rate cuts next year could allow the bears to jump back into the action from near the downside line drawn from the high of February 10 or near the 1.0200 zone, marked by the highs of September 12 and 13. The down wave may result in a break below the 0.9860, thereby confirming a lower low and taking the pair into territories last tested in 2002. The next support could be found at 0.9615, marked by the lows of August 6 and September 17 of that year, the break of which could carry extensions towards the inside swing high of September 17, 2001, at around 0.9335.

For the dollar to enter in a defensive mode against its European counterpart, a break above 1.0370 may be needed. Euro/dollar would be already above the aforementioned downside line, while the move would confirm a higher high on the weekly chart. This may encourage the bulls to climb towards the 1.0615 or even the 1.0770 barriers, marked by the highs of June 27 and 9 respectively.

Inflation expectations add to no-cut narrative

The latter scenario appears to be the least likely, as another factor arguing against any rate cuts next year is that inflation expectations indicators, even though they have come off their highs lately, still point to a rate well above the Fed’s objective of 2% in a year’s time. Over and above that, with the Fed adopting an average inflation targeting in 2020, just hitting 2% may not be enough. Officials may opt to hook inflation there for some time, or even push it briefly below target.

The weekly balance sheet data from the Fed showed an increase of 10.4 billion – a very unexpected change as the central bank should, on the contrary, have accelerated the balance sheet reduction since the beginning of September.

However, so far, the Fed has broadly stuck to its plan. The official release on May 4 stated that the balance sheet would be comprehensively reduced by a maximum of $47.5 billion per month from June 1. Over the 13 weeks of the summer, the reduction is $89bn, which is very close to the stated targets. It is also worth noting that the Fed has some headroom, as the balance sheet peaked at $8.946bn in mid-April, having shrunk by almost $133bn in that time.

The latest weekly data might be nothing more than a short-term divergence from the trend, while in the coming weeks, the Fed will intensify balance sheet sales at double the rate they did last summer. Add to that the 20% chance that the Fed will raise interest rates on Wednesday by 100 points at once, i.e., increasing the already unprecedented rate of policy tightening, and you get the perfect mix for the market storm we saw starting a week ago.

At the same time, unnecessary fears that the Fed will hike rates harshly are creating speculative potential. A 75-point rate hike will cause overvaluation in the markets as this 20% chance of a tougher move will be recouped. A change in longer-term expectations has an even more significant potential impact on the market.

The markets are now pricing in a 200-point increase to 4.25-4.50% on February 1, 2023, and the Fed will keep rates at that level at least until next year’s end. A change in these expectations in either direction would be a significant driver for markets after the Fed.

An increase in the level from which the rate will plateau will press the markets and support the dollar. The opposite is also true. With a lower expected key rate, recovery in equities could begin and the dollar’s rise risks slowing or reversing.

Natural gas futures (October 2022 delivery) have drifted lower again after their recent advance failed to cross above the 9.210 mark. Even though the latest downward spike seems to have encountered significant support at the lower Bollinger band, the near-term technical picture is constantly deteriorating.

The momentum indicators also reflect that bearish forces have gained the upper hand. Specifically, the stochastic oscillator is descending in the oversold territory, while the MACD histogram has dived below both zero and its red signal line.

In the negative scenario, further declines could meet support at the 7.000 psychological mark. Should that floor collapse, the bears could aim for 6.450 before the July low of 5.310 appears on the radar. A break below the latter may open the door for the 4.280 hurdle.

Alternatively, if buyers attempt to push the price higher, the recent support of 7.750 might provide immediate resistance. Violating this region, the price could ascend towards the 50-day simple moving average (SMA), currently at 8.320. Even higher, the recent peak of 9.210 could prove to be a hard ceiling for the price to break through.

All in all, natural gas futures appear unable to reverse their recent downfall as negative momentum is constantly strengthening, but the commodity retains a bullish medium-term outlook. For that to alter, the price needs to dip below the 5.310 floor.

The Swiss franc has started the week in negative territory. In the North American session, USD/CHF is trading at 0.9674, up o.31%.

Swiss National Bank to continue tightening

The Times They Are a Changin.

This is nowhere more apparent than in Switzerland, where the SNB is poised to end the negative rate era on Thursday. The safety of the Swiss franc has allowed the SNB to offer negative rates to investors, who were only too happy to park their funds during times of uncertainty, of which they have been plenty. While the Swissie’s value as a reliable safe haven asset hasn’t changed, what has changed is a world of low inflation, particularly after the Russian invasion of Ukraine.

Switzerland’s inflation is running at an annual clip of 3.5%, for which many central bankers would give their right arm. Still, inflation is on the rise and has become enough of an issue for the SNB that in June, it raised rates by 0.50%, bringing the benchmark rate to -0.25%. At the time, inflation was at 3.4%, its highest level since 1993. The rate hike hasn’t lowered inflation, which rose to 3.5% in August. The SNB is expected to strike again, with the markets having fully priced in a 75bp increase at the Thursday meeting, with a possibility of a massive full-point hike. Barring a huge surprise, this marks the end of the negative rate era, and I would expect the Swissie to gain ground if the SNB raises rates by 0.75% or 1.00%.

The Federal Reserve meets a day earlier, on September 21st, and is also expected to deliver a 0.75% rate increase, with an outside chance of a 1.00% hike. The US economy has been performing fairly well, allowing the Federal Reserve to continue tightening policy as it grapples with high inflation.

USD/CHF Technical

• USD/CHF is testing resistance at 0.9720. Next, there is resistance at 0.9760
• There is support at 0.9642 and 0.9524

The USDJPY stands at the front foot on Monday, though still within a narrow consolidation under new 24-year high, which extends into third consecutive day.

Last week’s bullish close market the fifth straight weekly advance, as the dollar remains robust on expectations for another large rate hike by Fed and safe haven flows on growing uncertainty on looming recession.

Bullish technical studies underpin the action for a final push through key 145 barrier, where the action recently failed twice, keeping the pair in extended consolidation, but double-rejection of dips at 141.50 zone, suggesting that the downside is well protected for now.

All eyes are on central banks, as the Fed is widely expected to deliver another 0.75% hike on Wednesday, with some expectations for even more aggressive action and 1% hike that would strongly inflate the dollar.

On the other side, the Bank of Japan is expected to keep its ultra-loose policy unchanged on Thursday that would further widen the divergence between two monetary policies and add pressure on Japanese yen.

Near-term bias is expected to remain firmly bullish as the action stays above 141.50 zone, however, possible deeper dips need to stay above psychological 140 support to keep overall bullish structure intact. Eventual break of 145 pivots would risk fresh acceleration and unmask 1998 peak at 147.68.

Res: 143.80; 144.11; 144.55; 144.99.
Sup: 142.64; 142.00; 141.50; 140.94.