Cliff Notes: policy makers’ views on risks begin to diverge
Key insights from the week that was.
The past week has seen a flurry of central bank communications as the RBA, FOMC and BoE all met to deliberate on policy. Evident In their decisions and commentary is a growing divergence in expectations around inflation and the risks to the policy outlook.
Despite the much stronger than expected Q3 CPI report, the RBA delivered only a 25bp hike at its November meeting. However, their revised forecasts for inflation in 2022 and 2023 (from 7.8% to 8.0% for 2022 and 4.3% to 4.75% for 2023) highlight the current strength of price pressures in Australia and their expected persistence. Consequently, we remain confident in our peak of 3.85%, with 25bp increases to be delivered in December, February, March and May.
Following the RBA’s decision, Chief Economist Bill Evans provided a detailed analysis of the outcome as well as the implications and risks. Note, as we go to press, the RBA’s latest Statement on Monetary Policy has also just been released, giving full detail on their own expectations regarding the outlook and risks.
This week’s Australian data flow meanwhile largely focused on housing. CoreLogic’s 8 capital city measure reported a 1.1% fall for October, leaving prices 6.6% below their peak level. The pace of price declines slowed in Sydney and Melbourne, but accelerated in Brisbane. Adelaide and Perth continue to show resilience, although prices are also beginning to slip there. Dwelling approvals meanwhile saw a material 5.8% decline in September following a number of upside surprises, with the weakness broad based. Ahead, further significant declines are expected, with affordability; the cost and availability of inputs; and general economic uncertainty all set to weigh on activity. This deterioration in new activity will feed through to GDP as well as the demand for housing credit. Note, at September, housing finance approvals were 26% below their peak of early 2022.
This week we also received an update on Australia’s trade position. September’s report was a positive surprise for exports which gained 7% on resilience in commodities and another strong showing for services. However, imports also faired better than expected. While the Q3 surplus of $30bn is another strong result, it is down from $44bn in Q2. Factoring in our expectations for price changes, this points to net exports’ contribution to GDP growth swinging from +1.0ppts in Q2 to -0.75ppts in Q3.
Before moving further afield, it is also worth highlighting that New Zealand’s labour market showed resounding strength this week, with the unemployment rate remaining near its record low in Q3 as employment grew rapidly. Wages also showed strong momentum, the labour cost index gaining 1.1% in Q3 to be 3.7% higher over the year. These results argue for an outsized 75bp increase in the cash rate at the RBNZ’s November review, in line with Westpac’s existing expectation. A peak of 5.0% is seen for the cash rate in 2023.
Turning to the UK. After a few tumultuous weeks in politics and markets, the Bank of England delivered a 75bp rate hike in November, raising the bank rate to 3.0%. While this represents strong progress towards tackling inflation, the Committee’s rhetoric and projections surrounding the economic and policy outlook has clearly shifted into more ‘dovish’ territory. Indeed, based on the market-implied path for the bank rate, the UK economy is expected to remain in a deep and prolonged recession through to H1 2024, coinciding with still elevated consumer inflation and a material weakening in the labour market, with the unemployment rate expected to almost reach 6%.
Reflecting on this, Governor Bailey emphasised in the press conference that market pricing has gone too far. A subsequent scenario analysis involving fixed policy at the current rate of 3.0%, albeit still bleak, produced a shallower recession and an inflation rate closer to the 2% target. On balance, inflation is still far too high and interest rates must rise further, but a slowing in the pace of rate hikes is very likely. Hence, we expect only 100bps of tightening remains in the cycle, bringing the bank rate to a peak of 4.0% by March 2023.
Finally then to the US. Already fully priced, the FOMC’s decision to raise by 75bps in November was looked through, with participants instead focused on the detail and tone of the Committee’s guidance. The take home point from the statement and press conference is that, while the FOMC is close to throttling back on the pace of rate hikes (our baseline expectation is for a 50bp hike in December and 25bps in January), with inflation risks still skewed upward, the FOMC believe they have more work to do before the hiking cycle concludes.
While we believe inflation will continue to decelerate through 2023, there is a question as to how patient the FOMC is willing to be in assessing the cumulative economic effect of policy tightening. Also critical will be how market participants price expectations for growth and inflation into nominal and real yields.
Clear from Chair Powell’s remarks is that the Committee is intent on maintaining tight financial conditions until the risks around inflation subside. This requires real yields to remain materially above zero. Implicit here is that, if real yields decline in the months ahead, the FOMC may look to continue tightening towards mid-2023 beyond our current peak of 4.625% at January/February 2023. Rate cuts are expected to remain off the FOMC’s agenda until 2024.
The risk for the US is clearly that this tight stance of policy leads to recession and/or a prolonged period of sub-trend growth, even after rates begin to decline in 2024. Our growth forecasts and expectations are laid out for the US and the world in our just released November Market Outlook on Westpac IQ.
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