Cliff Notes: short and medium-term risks, an uncomfortable tension for policy makers
Key insights from the week that was.
Short on domestic data releases, the focus this week was a speech from RBA Governor Lowe which explored a number of key issues facing monetary policy. He discussed four current trends within the global economy that are contributing to growing inflexibility on the supply-side, including: deglobalisation and barriers to trade/investment; the projected decline in working-age populations in advanced economies; climate change, and the energy transition towards low carbon-intense emission technologies. Arguing that these trends can lead to an increase in the prevalence of supply shocks, he advocated for productivity-enhancing policies and flexibility for inflation targeting (2-3%yr, over the medium-term) to ensure the strength of the nominal anchor amid an increasingly uncertain environment.
Regarding the current stance of policy, Governor Lowe reiterated that the RBA is not on a pre-set path, leaving the door open to pause or return to 50bp moves. As discussed by Chief Economist Bill Evans earlier this week, given the strength of the labour market, as evinced by the fall in the unemployment rate to a 50-year low (3.4% in October) and the strength of private sector wages growth (3.4%yr in September), we expect the cash rate to be increased by 25bps at the December, February, March and May meetings to a peak of 3.85% in May 2023.
Central banks also remained front of mind outside Australia. Fearing that inflationary forces are becoming embedded in New Zealand’s economy, the RBNZ raised their cash rate by 75bps at the November meeting and signalled that further increases to 5.50% by early-2023 would likely prove necessary. The RBNZ also made clear the scale of the shock to activity they expect will be required to quell inflation and wage pressures, forecasting a downturn similar in scale to New Zealand’s GFC experience.
Arguably time is too short to dissuade the RBNZ from hiking to 5.50% (Westpac NZ’s revised expectation is in line with the RBNZ), but our New Zealand team is becoming increasingly concerned over the consequences of the tightening cycle, with rate cuts now forecast to begin six months sooner in early-2024. A fact that needs to be kept in mind is that New Zealand’s fixed mortgage rate structure is delaying the impact of policy. As discussed in our New Zealand team’s latest quarterly (released a fortnight ago), this will change materially over the coming year.
In the US meanwhile, the market keenly awaited the mid-week release of the FOMC’s November meeting minutes, hoping for a sign that the FOMC consensus was shifting to a slower pace of hikes from December. They got such a signal: at the November meeting, “a substantial majority of participants judged that a slowing in the pace of increase would likely soon be appropriate”. This fits with our expectation that the pace of rate hikes will slow to 50bps in December, then 25bps at the January/ February meeting. For the resulting 4.625% fed funds rate to prove the peak for this cycle however, we need to see a further deceleration in inflation and increase in labour market slack. Financial conditions also have to remain tight – to our mind, the best simple guide for this metric is the 10-year Treasury yield holding near 4.0%, currently 3.7%.
Most important in the November meeting minutes was actually the degree of uncertainty apparent to the FOMC over inflation pressures and risks; growth in employment and wages; the scale and timing of policy lags; and the eventual impact of all these factors on financial conditions, activity and sentiment. The FOMC’s holistic assessment of these issues could see them take an increasingly cautious view on the outlook for activity now that policy is contractionary, our baseline view; but their experience with inflation over the past year could also rule the day, resulting in a more aggressive approach, at the cost of growth in 2023 and beyond.
The next few months of data updates will therefore prove critical for both the short and medium-term health of the US economy. With the S&P Global manufacturing and service PMIs having disappointed materially In November, with outright contractionary readings reported this week, it will be interesting to see the ISM outcomes over the next fortnight. The ISMs have a narrow focus on large firms with strong market positions; so, if they are also feeling pressure, a material deterioration in the US economy has likely begun.
Moving over to Europe, the ECB’s October Meeting Minutes emphasised the growing concern over the underlying breadth of inflation, but it is clear the Governing Council also remains cognisant of the risks to growth. Although the region has exhibited an unexpected resilience in activity through 2022, the ECB is set to factor in a materially weaker result for growth in the December quarter, supporting an easing in the pace of rate hikes from 75bps to 50bps. The limited run of data releases over the week also echoed this risk. With consumer confidence printing a very weak -23.9 in October and the November S&P Global manufacturing and services PMIs holding in contractionary territory, rising prices and interest rates are clearly weighing heavily on the economy moving into year-end. Hence, we continue to favour a step-down to 50bps at the December meeting, though risks are skewed to the upside should inflation print materially above expectations.
Finally to China. Uncertainty over the road out of COVID-zero persists, with local authorities much more cautious over the spread of the virus than central authorities’ recent ‘policy adjustments’ imply. New COVID-19 cases are currently around the highs of the pandemic, although reports of severe health outcomes have been limited and the total count of infections does not seem to be multiplying rapidly. As things stand, we continue to believe central authorities will stick to their plan for a progressive re-opening of the domestic economy, although confidence will take until mid-2023 to build. The expected recovery in consumption will therefore remain the chief risk for the growth outlook for the foreseeable future.
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