Cliff Notes: RBA & FOMC on hold as ECB & BoE remain on tightening path
Key insights from the week that was.
This week, the RBA decided to leave policy unchanged for a second consecutive month. As was the case in July, the Board’s decision reflects a preference to ‘wait-and-assess’ the evolution of risks as the cumulative impact of policy tightening is increasingly felt. Curiously, the RBA has retained the same forecast track for inflation following a better-than-expected Q2 CPI print, with headline inflation still expected to reach 3.25% by the end of 2024. The RBA’s Statement on Monetary Policy (due for release at 11:30am) will provide a full update of the staff forecasts; and, of particular interest, more clarity over how far into the 2–3% target range the RBA expect to be by end-2025. Nevertheless, the Board has retained a clear tightening bias and likely will continue to do so over the near-term as risks are assessed.
As discussed by Chief Economist Bill Evans in a video update midweek, we believe this decision likely confirms the end of the RBA’s tightening cycle. Although the September meeting certainly remains ‘live’ – the Monthly CPI Indicator and WPI could surprise – our central case is that policy will remain on hold from now as evidence of a slowing economy, moderating inflation pressures and a gradual emergence of slack in the labour market continue to build over the coming year. In our view, these dynamics warrant an interest rate easing cycle starting from Q3 2024, with a 25bp rate cut per quarter until a broadly neutral level is reached for policy, ensuring growth sustainably returns to trend as inflation nears target.
The lower-than-expected peak in the cash rate and a firmer labour market – the unemployment rate set to rise to only 3.8% in 2023 and 4.7% in 2024 – will put less pressure on the Australian consumer over H2 2023 and 2024 than we had initially anticipated. The consumer sector will be coming off an already weak base, associated with deteriorating real incomes and spending capacity, also highlighted by the large contraction in real retail sales through H1 2023. So, while the improvement in our consumption forecast (0.8% in 2023; 0.9% in 2024) has lifted our view for GDP – from 0.6% to 1.0% in 2023 and from 1.0% to 1.4% in 2024 – these results are still characterised as very weak versus history.
Before moving offshore, a quick note on housing. This week’s data raised more questions about the sustainability of the housing market’s current momentum given the elevated level of interest rates. Indeed, while CoreLogic’s home value index posted another broad-based gain in July (0.8%), this represented a continued moderation in the pace of price gains from May (1.4%) and June (1.2%). The fall in housing finance approvals also provided a tentative signal of growing uncertainty in borrowers’ interest in the housing market, with clear weakness in loans for existing dwellings apparent. A sizeable pipeline of work is currently holding up housing construction but, abstracting for high-rise volatility, dwelling approvals' weak trend suggests housing construction activity will decline over the coming year. Housing supply is therefore likely to remain constrained to end-2024 and beyond, supporting the level of both prices and rents.
Offshore, the Bank of England raised its Bank Rate by 25bps to 5.25%. Strong momentum in wages and resilience in GDP growth justified the Committee’s decision in August and point to further hikes ahead. Despite the significant deceleration in inflation in June (7.9%yr from 8.7%yr in May) and a belief that policy is contractionary, inflation risks remain skewed to the upside and two members of the Committee felt a 50bp move would have been more appropriate in August. Despite services inflation having accelerated for four consecutive months, the Committee seem optimistic that the trend will top out, projecting it "to remain elevated at close to its current rate in the near term." Signs that the labour market is coming into better balance and a weaker forecast profile for the unemployment rate support this view.
The forecasts for inflation overall, which are predicated on a market implied rate around 6% in 2023 and 2024, point to inflation a bit above target in 2024, but back at 2%yr in Q2 2025 and below that level near end-2025. GDP growth is expected to be materially below potential through 2023-25, creating a sizeable output gap, and so the longer-run expectation for inflation based on the market-implied rate path has to be below target. While the risks regarding inflation calls for further rate hikes in the near-term, the current market-implied rate for 2025 of 5% seems improbable. Growth below trend and inflation below target in 2025 would instead argue for a neutral or accommodative stance at that time; history points to that level being a fraction of 5%.
Close by, Europe's flash HCIP showed prices grew 5.3%yr in July versus 5.5%yr in June. Core inflation remained unchanged at 5.5%yr while services inflation accelerated to 5.6%yr. While not alarming, the August report will need to show more improvement for the ECB to stay put on rates. Regardless of the August CPI outcome, it seems prudent to us for the ECB to hike once more in September and then go on hold till mid-2024 at a restrictive level to guard against inflation risks, particularly as the labour market remains strong and economic activity resilient.
Across in the US, the ISM Manufacturing PMI for July ticked up to 46.4 points, although that still marks nine consecutive months of contraction. There was an improvement in new orders and production reversed some of last month's fall, but both sub-indexes remained below 50. Meanwhile, the employment sub-index fell to a deeply negative reading of 44.4, suggesting US manufacturers are increasingly of the view that conditions will remain weak and current staffing is excessive. The services ISM PMI also subsequently disappointed in July, coming in at modestly expansionary 52.7. The softening was broad-based but most notable for employment which at 50.7 is now consistent with little-to-no growth in employment. Admittedly, both of the ISM employment indexes have been volatile over the past year, but the trend is clear: in aggregate, US businesses are increasingly of the view that they do not need additional staff and may indeed have too many workers; into year end and through 2024, the unemployment rate is likely to rise and wage growth slow back to average levels.
In China, the NBS manufacturing PMI meanwhile rose 0.3pts to 49.3, leaving it 1.2pts below the 5-year pre-COVID average. The largest improvement was in new orders and raw material inventories, though both remained below 50. The NBS non-manufacturing PMI however weakened to 51.5, with a particularly notable decline in new orders. The level of both NBS PMIs corroborate other evidence of excess capacity in China’s economy from the CPI and PPI. Yet, from the fixed asset investment data and given recent encouragement by authorities, it is clear additional capacity will come online over the next year. With developed world demand weak, this can only lead to further goods disinflation or outright deflation for some products globally. We see this trend continuing to aid the return of western inflation back towards trend, though to fully achieve this aim also requires services inflation in developed markets to ebb, a problem the West will have to resolve themselves.
As a final point, the BoJ decision last week to expand its 10-year trading range to +/-1.0% from +/-0.5% to improve the sustainability of YCC further highlights the need to continue to assess each nation’s inflation path and contributing factors carefully. Wage and capacity trends will continue to vary greatly between the US, Europe, Japan and developing countries like China; so too then will monetary policy outcomes. A full discussion of the implications for FX markets will be available in our August Market Outlook due for release on Westpac IQ today.
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