Key insights from the week that was.
The past week has again been all about inflation and central bank expectations.
While the headline Australian CPI print for Q3 was in line with our expectation at 0.8%, the trimmed mean core was materially higher than forecast at 0.7%, taking the annual rate above the bottom of the RBA’s 2-3%yr inflation target for the first time since Q3 2015 (2.1%yr at Q3 2021). The primary drivers of aggregate inflation in the quarter were new dwelling purchase prices (3.3%) and auto fuel (7.1%). Notably for the outlook, the rise in dwelling purchase prices as a result of the unwinding of the HomeBuilder grant was smaller than anticipated; the greater contribution of fundamentals in Q3 and the future unwind of this grant’s effect points to a stronger outlook for this component.
Despite the upside surprise for Q3 trimmed mean inflation and markets rushing forward the timing of RBA rate hikes — three rate hikes to 0.75% are now fully priced by November 2022 — as outlined by Chief Economist Bill Evans yesterday, we continue to expect the first rate hike to come in February 2023, to be followed by a modest tightening cycle to 0.75% late-2023 and 1.25% in 2024. This sequence of hikes will occur after full employment is achieved (end-2022) and as inflation is sustained in the RBA’s target range.
Offshore, inflation also remained front of mind this week as two key central banks met. The Bank of Canada surprised by calling an abrupt end to its balance sheet expansion and by bringing forward guidance on the likely timing of a first rate hike, albeit only by a few months to mid-2022. While they recognised the recent surge in inflation due to supply-chain disruptions and energy prices as being more persistent than previously thought, progress in the labour market and in depleting slack in the economy more broadly remained the primary focus of the Governing Council’s policy making process.
In short: employment growth has outperformed expectations to date in the recovery and job openings remain elevated; amongst the Council, this has fostered a belief that slack in the economy will be used up by mid-2022, leading to the bringing forward of their rate guidance. Note though: if the labour market disappoints, the timing of the first rate hike can be pushed back; conversely, if global or domestic inflation surprises to the upside and is built into expectations, an earlier hike could be seen.
The ECB took a similar approach to their communications in October. President Lagarde also recognised that the effect of supply-chain disruptions and energy prices were going to be more significant and longer-lasting than previously anticipated. But these factors were given little weight when it came to the outlook for policy owing to their limited effect on inflation expectations. Instead, like the Bank of Canada, US’ FOMC and Australia’s RBA, the ECB continues to focus on remaining slack in the economy.
While the Euro Area’s labour market fared well through the pandemic thanks to wage subsidies, cyclically and structurally there is still considerable slack to erode via above-trend growth. As a consequence, the ECB is ready and willing to maintain asset purchases for a lot longer than the other central banks noted above. Indeed, it seems probable the open-ended Asset Purchase Program (APP) operational before the pandemic will continue indefinitely and, for a time, be supplemented by additional purchases after the pandemic envelope (PEPP) is closed end-March 2022. Any move on interest rates by the ECB therefore seems distant.
Next week, the run of central bank meetings will continue, with the Bank of England and US FOMC. While the market has moved to price a rate hike by the Bank of England of 15bps to 0.25%, the most significant development for global financial markets will be the FOMC’s formal taper announcement. Based on comments made by FOMC members before the pre-meeting blackout, this decision will put in place a timeline to end asset purchases around mid-2022. While the market has priced in quick follow-through for interest rates — a fed funds rate hike is now priced by July 2022 — such a rapid move is far from certain. Chair Powell and the FOMC have made clear time and time again they also see global influences for inflation as transitory and that the US labour market has considerable ground to make up. Very strong growth in employment as well as rising inflation expectations are likely necessary to see the Committee act with haste following the end of the taper.
Given the disappointing Q3 GDP report received overnight, an at-trend gain of 2% annualised largely as a result of weaker consumer demand, and continuing restrictions on the supply of labour, such an outturn for rates seems unlikely. Instead we continue to believe a pause in policy will be seen after the end of the taper till December 2022, when the first US hike will be delivered.
Also note that we remain of the view that this rate hike cycle will prove modest versus history across the world. As an example, for the US we expect it to end at 1.625% in 2024, below the FOMC’s longer-run guidance of 2.5% as well as the FOMC’s 2.0%yr inflation target – the latter meaning the real fed funds rate will still be negative at the peak of the cycle. Such an end point for this cycle is justified in our mind by years of below-target underlying inflation, suppressing expectations; a continued focus by business on efficiency; and the existing (and growing) level of global debt which means every basis point increase in interest rates is felt much more by borrowers than in the past.
