Key insights from the week that was.
The RBA and ECB were the focus for market participants this week. Both made a stand against inflation and associated risks consistent with their individual circumstances.
The 50bp hike delivered by the RBA in June was twice the market’s expectation of 25bps. It signals greater concern over the inflation outlook which the statement suggests is based on both external (global supply concerns and energy prices) and domestic pressures (the historically-tight labour market and other supply restrictions). The breadth and scale of these pressures warrants further decisive action by the RBA in coming months to highlight their determination to remove inflation risks.
As a result, we now look for an additional 50bp hike in July followed by a 25bp increase in August after the next CPI report and another 50bps split over the November and December meetings, taking the cash rate to 2.10% at year end. One final 25bp hike is anticipated to be delivered at the February 2023 meeting to leave the cash rate at 2.35% at peak, a level we believe to be materially above neutral given households’ high debt levels.
A full view of the outlook for the RBA and the risks was provided by Chief Economist Bill Evans in this week’s video update. Detail on our revised inflation view was also released. On the latter, the startling surge in domestic energy prices being seen currently in Australia leads us to believe that headline CPI inflation will now peak at 6.6%yr at end-2022 and only slowly decline to the top of the target range through 2023. Annual trimmed mean inflation is expected to peak at 4.8%yr in the second half of 2022, but also come back to around 3.0%yr through 2023.
The circumstances being experienced by the Euro Area and the ECB are very different to those Australia faces. Of particular note for Europe: growth is at risk of stalling for an extended period; considerable slack remains outside their labour market; and, of course, Russia’s invasion of Ukraine is creating immense uncertainty for the region. Nonetheless, the ECB finds itself needing to fight against historic inflation pressures and risks.
The ECB’s revised profile for inflation makes clear the scale of the threat, headline inflation now forecast to end 2022 at 6.8%yr (prev 5.1%yr), 2023 circa 3.5%yr (prev 2.1%yr) and 2024 2.1%yr (prev 1.9%yr). President Lagarde was clear in the press conference that the above view of inflation requires decisive action, starting with a 25bp increase in July. However, the underlying interest rate assumption for their June forecasts, average short-term interest rates of “0.0% in 2022” and “1.3% in 2023”, makes clear that the July decision is just the start of Europe’s policy normalisation.
Beginning with the September decision, in her prepared remarks President Lagarde stated that if “the medium-term inflation outlook persists or deteriorates, a larger increment [than 25bps] will be appropriate at our September meeting”. In the Q&A, she clarified this position, outlining that if inflation is seen “at 2.1% in 2024 or beyond” then “yes”, “the increment adjustment will be higher”.
What is also important to recognise is that these early rate hikes do not only apply to the deposit rate, “the key ECB interest rates – the three of them” will all be raised. Later in the press conference, President Lagarde mentioned that “keep[ing] those spreads or return[ing] to a better symmetry between those three [rates]” was still to be debated for hikes beyond September.
Given the Council’s concern over inflation to end-2024 and belief in the underlying strength of the economy, it seems most probable that July’s 25bp hike will be followed by a 50bp move in September, taking the refi rate to 0.75%. Assuming that risks to growth subside between now and November, another 50bp hike at that meeting seems consistent with their focus of making sure medium-term inflation is at or below 2.0%yr. Another 25bps in December would bring the refi rate to 1.50%, the mid-point of the neutral range of 1.0-2.0% previously cited (but still being debated), and be a clean end to the tightening cycle.
Our more bearish view on growth in 2022 and 2023 2023 (2.1% and 1.5% respectively versus the ECB’s 2.8% and 2.1%) makes clear the risks to this course of action. Further, history suggests that, when rates rise in Europe, often there are consequences for credit availability and spreads. If our view of growth and/or the concerns we have over credit prove more accurate than the ECB’s over the coming half year, some of the above rate hikes could be delayed and/ or jettisoned.
One final point on China before concluding for the week. We remain more optimistic on the rebound from the recent COVID-zero lockdowns. This week’s May trade balance gave us more reason to be so. From 1.9%yr in April, annual export growth rebounded to 15.3%yr in May against market expectations of a 9.2%yr result. Further, the snap back in import growth was not as strong as anticipated, from -2.0%yr in April to 2.8%yr in May. As a result, the trade balance widened from $51.1bn last month to $78.8bn, some $20bn above the consensus estimate. Clearly authorities are prioritising removing impediments to trade, particularly for exports; GDP in Q2 should therefore receive strong support from net exports, as we have long held. The real test for China’s economy will come as investment then consumption is ramped up through the remainder of the year.
