Key insights from the week that was.
The past week has been notable for a global resurgence in risk appetite despite a run of data pointing to deteriorating US economic growth. Principally this is because the softer tone of US data and the FOMC’s recognition of it implies a receding risk of rate hikes in excess of those already priced.
Having delivered a second-consecutive 75bp fed funds rate hike to a mid-point of 2.375%, Chair Powell showed a greater degree of comfort over the outlook for inflation in the July press conference. In part this stems from 2.375% being within the 2-3% interest rate range the FOMC believe to be neutral for their economy. However, the greater comfort vis a vis inflation is also a consequence of building apprehension over the outlook for growth. Notably, the press conference also made clear that the FOMC wish to undertake “just the right amount of tightening” to bring about below-trend growth, “not make a mistake” by creating the pre-conditions for recession – as defined by the NBER.
After the July FOMC meeting, Q2 was confirmed as a second consecutive quarter of contraction for GDP, giving further weight to the nascent concerns of Chair Powell and the Committee. Importantly, whereas the weakness in Q1 was principally due to net exports and inventories, in Q2 a marked deterioration in domestic final demand was seen – annualised growth falling from +2.1% in Q1 to -0.1% in Q2. Pricing for the FOMC fell further as a result to now be broadly in line with our own view – a 50bp hike in September followed by only two 25bp hikes come November and December.
Arguably risks to this view are also transitioning from being biased up to skewed down. The most likely catalyst to cement such a change is the weakness recently seen in household survey employment – flat over the three months to June – becoming apparent in nonfarm payrolls and hourly earnings. Along with persistent weakness in domestic demand, a material weakening in these labour market variables would begin to fit the definition of an NBER recession and warrant greater caution be taken with policy. August 5 and September 2, the next two release dates for the US employment report, therefore loom as critical dates in the run to the September FOMC meeting.
Regardless of how the US rate hike cycle concludes in 2022, come 2023 we believe the policy debate will shift to the timing and scale of rate cuts as US economic growth languishes below trend and inflation pressures recede. We are more cautious on the timing of policy easing than the market, holding that it won’t begin until late-2023; however, we expect the easing to be material in scale, in the order of 125bps by end-2024.
Australian equities and our dollar have benefitted from this week’s recalibration of US economic risks. This is despite domestic data releases which pointed to a modest softening in consumer demand in May/June and a sharp decline in real household disposable income through Q2.
Australia’s retail sales posted a soft gain of 0.2% in June, rounding out a 3.2% lift for Q2 after a similarly strong 2.9% increase in Q1. The COVID-19 reopening and normalisation of spending patterns is a key factor here, although strong price inflation over this year has also supported nominal sales. Solid momentum should sustain in the near-term, but come late-2022 and into 2023, the RBA’s aggressive tightening cycle is expected to see an abrupt slowing in household spending. For full detail on the Australian consumer, see the latest edition of Westpac’s Red Book.
The Q2 CPI report also made clear that household incomes have been, and will continue to be, hit by historic inflation, headline and trimmed mean inflation coming in as expected at 1.8% and 1.5%. At 6.1%yr and 4.9%yr, annual inflation to June is a multiple of aggregate wage growth across the economy, the latest estimate for the wage price index being 2.4%yr at March. The largest contributor to the headline CPI result was housing costs (0.6ppts), driven higher by a lack of supply of inputs and labour and, at the margin, the unwinding of the benefit provided to households by the Government’s HomeBuilder grants in recent years.
Supply also impacted the cost of transport, household contents, apparel and food in the quarter and over the year; although for fresh food, the primary catalyst was east coast flooding rather than global supply chain and geopolitical concerns. Ahead, we continue to expect the pressure on households from inflation to persist, with annual headline inflation forecast to trend higher through H2 2022 to a peak around 7%yr in December and thereafter to take all of 2023 to come back near the top of the RBA’s target range.
Chief Economist Bill Evans discussed the implications of Australian inflation for the RBA outlook and the economy following the Q2 CPI release. In short, inflation’s Q2 result and outlook support our view that the RBA will need to raise the cash rate to 3.35% by February, with 100bps of the 200bps of cumulative hikes to come in August and September. To the extent that this level of the cash rate is materially above our estimate of neutral, the cost to the economy of bringing inflation back to target will be material, with GDP growth to slow in 2023 to just 1.0%yr and the unemployment rate rising to around 5.0% late-2024, approximately 2ppts above the low we forecast for late-2022.
