Key insights from the week that was.
Recent developments have led us to change our view on the RBA and FOMC ahead of their respectively policy meetings next week.
The Australian Q1 CPI report delivered a downside surprise on underlying inflation, the trimmed mean measure print of 1.2% (6.6%yr) well below the market’s expectation and our own. This was largely associated with a broad-based step-down in the pace of goods inflation, from 9.5%yr to 7.6%yr, with softness emerging more clearly, particularly across food, recreation, clothing/footwear and household contents. While annual services inflation recorded a large increase (6.1%yr from 5.5%yr) due to a surge in health care costs and housing utilities – components which were likely ‘trimmed’ out of the underlying measure – the easing in annual headline inflation, according to the RBA’s February forecasts, is running ahead of expectations.
Given these developments, as discussed by Chief Economist Bill Evans, we now expect that the RBA will extend their policy pause in May, keeping the cash rate at 3.60%, a level which we now believe will prove the peak for this tightening cycle. With inflation set to remain in a clear down-trend and slack to emerge in the labour market over coming months, we anticipate that the scope for further interest rate increases will fade in time. Nevertheless, a tightening bias from the Board is to be expected near-term given inflation is still elevated and the labour market historically tight.
Offshore, the week also began quietly, with the US’ regional Fed surveys and housing partials the only data of note. All but one of the regional surveys showed a marked deterioration in activity and sentiment for US business in April. These outcomes were corroborated by a downside surprise for core durable orders and shipments which declined for a second consecutive month in March. Taken together, these outcomes point to business rapidly shifting to a defensive posture. We expect this trend to persist and result in a further marked deceleration in job creation and wage growth through 2023 as well as continued weakness in business investment.
While consumption showed strength in Q1, rising 3.7% annualised versus GDP’s 1.1% overall gain, the detail of the GDP report and monthly PCE data makes clear that this momentum was highly concentrated in durables spending and was front-loaded in January. February subsequently saw a marginal decline and, assuming an unrevised February outcome, the Q1 outcome points to another small decline in the month of March. More broadly, the deceleration evident for employment and wage growth, sub-par consumer confidence and challenging housing affordability all speak to a lengthy period of weakness in consumption. It is unsurprising then that businesses stopped accruing inventory in Q1. The potential for inventory stocks to be sold down will linger as a downside risk to growth through the remainder of 2023.
Increasingly then it seems likely that the contraction in GDP we have been forecasting for the second half of 2023 will meet the broader NBER definition of recession. Moreover, risks to the recovery are skewing sharply to the downside given the weakened state of the US banking sector and the clear need for regulatory reform to increase oversight of smaller banks. While FOMC member communication ahead of the pre-meeting blackout suggests members see a need to take out a little more insurance against inflation risks in the near term, one more 25bp hike is now expected at their May meeting, the remainder of the year is expected to show a US economy under significant stress, with growing downside risks. As a result, we expect this last hike to be taken back in December and, with inflation around target on an annualised based by December, a further 200bps of cuts through 2024. Our end-2024 forecast for the fed funds rate is consequently unchanged at 2.875%.
