Key insights from the week that was.
Three key developed market central banks met this week. All raised rates and, to varying degrees, highlighted the risks pertaining to inflation.
In Australia, the RBA surprised the market consensus by announcing a 25bp increase in the cash rate to 0.35% instead of 15bps. The downward revision in the unemployment rate to 3.5%, a level it expects will be maintained through 2023, emphasises the strength of Australia’s economy and gives cause to begin removing accommodation. Doing so quickly however is justified more by their revised expectations of inflation, the RBA’s view on underlying inflation at end-2022 revised up 2ppts to a materially above-target 4.75%. The full detail of the RBA’s forecasts will be provided today in the May Statement on Monetary Policy (released at 11:30am); but for policy, it is particularly notable that Tuesday’s decision statement reported underlying inflation is still expected to be at the top of the RBA’s target range in mid-2024 (3.0%, previously 2.75%).
As detailed by Chief Economist Bill Evans following the decision, given the RBA’s views and our own, Westpac believes it is appropriate to front-load the normalisation of policy, a 40bp hike to come in June and be followed by a string of 25bp increases in July, August, October, and November, taking the cash rate to 1.75% by year end. In 2023, we see two additional hikes in February and May to a peak cash rate of 2.25%. Given the high debt levels of Australian households, this level of rates is expected to materially reduce momentum through 2023, dissipating demand-driven inflation pressures and allowing the RBA to go on hold.
In the US, a similar perspective of the outlook was presented by the FOMC, albeit while recognising the greater risks the US currently faces from inflation. Very clearly, the FOMC has strong confidence in the US economy thanks to historically-low unemployment and strong consumer balance sheets. They also recognise the scale of the supply-side inflation pressures and the risk to inflation and wage expectations if actual inflation is not reined in quickly from 8.5%yr/6.6%yr on a CPI/PCE basis at March 2022 towards the 2.0%yr medium-term target. Consequently, the FOMC plan an aggressive start to the policy normalisation process, to be followed by ‘fine tuning’ as neutral approaches.
May’s 50bp increase is therefore expected to be followed by two more 50bp hikes in June and July to 1.875% — the lower-end of the Committee’s neutral range of 2-3%. Thereafter, we believe 25bp increments will be seen to a fed funds peak of 2.625% in December. Combined with the estimated policy impact of the FOMC’s quantitative tightening program, this level of fed funds would result in financial conditions historically consistent with a 3.0% fed funds rate – the top of the FOMC’s neutral range.
Westpac believes this level of rates will instead prove contractionary for the US, particularly after the loss of real income through 2022, and see growth slow below trend in 2023. It is also our expectation that headline inflation will drop from its current level back down to around 3.0% in six-month annualised terms at year end, then into the 2-3% range come 2023. Such an outturn would justify the FOMC going on hold in 2023 and cutting rates in 2024 to a more neutral level once the inflation threat has past.
The outlook for Australia and the US is therefore likely to prove challenging but sanguine, with growth near trend able to be sustained into the medium term and the stance of policy broadly neutral. Unfortunately, increasingly it seems the same cannot be said for Europe and the UK.
As detailed in our latest edition of Market Outlook (due for release on Westpac IQ today), recent developments have created immense uncertainty for Europe, with disruptions to gas supply moving from possible to probable while additional cost pressures are to be imposed on their economies by a phased reduction in coal and oil imports from Russia. The latter is most certainly justified as European authorities seek to force an end to Russia’s invasion of Ukraine through economic means, but nonetheless is another cost for Europe’s economy at a particularly trying time.
We have therefore lowered our growth view for the region, expecting the Euro Area economy will stall for the remainder of the year before a moderate recovery builds in 2023. To this revised view, risks arguably still lay to the downside. That said, if the conflict were to cease quickly, the hit to real incomes could reverse and the economy rebound strongly – on this point, it is worth remembering that before the invasion occurred, the Euro Area was primed for growth in 2022 at a multiple of trend.
The response of the market to the Bank of England’s May meeting was diametrically opposed to both the RBA and FOMC decisions, the combination of dramatically weaker growth forecasts and much stronger and persistent inflation expectations not to mention a third of the Committee preferring a 50bp hike to the 25bps agreed seeing risk appetite disappear during the US session.
Specifically on the UK economy, the BoE now forecast annual growth to be flat at Q2 2023 and a mere 0.2% come Q2 2024; while headline inflation is expected to print at 9.1% in Q2 and peak above 10% in Q4 2022 before falling to 6.6% in Q2 2023 and 2.1% in Q2 2024.
This portrait of stagflation signals an incredible challenge for the Bank to anchor longer-term inflation expectations without causing a deep recession. Tightening aggressively from here will produce a significant risk of enduring weakness in domestic demand, threatening a more severe and sustained output gap into the medium-term.
Finally, to China. While the headlines continue to highlight the market’s doubts over the ability of Chinese authorities to navigate through the current spate of COVID-19 outbreaks, we remain constructive. A full view is provided in the May Market Outlook. But at a high level, the combination of the resilience shown to March; the ready availability of credit across the economy; and the growing support from policy makers points to underlying strength that will show itself in the second half of the year.
By sector, near-term growth will be concentrated in public and private investment away from the affected regions of Shanghai and Beijing. As restrictions are removed, we hope sooner than later, this momentum will broaden geographically, and consumption will bounce strongly nationwide – with pent-up demand, income, and sentiment all supportive of sustained growth in spending. GDP growth near authorities’ 5.5% target is still readily achievable in 2022 and beyond.
