Cliff Notes: dealing with uncertainty
Key insights from the week that was.
In Australia, the Q4 CPI printed modestly to the downside of Westpac’s expectation and the market consensus, headline inflation rising 0.2% (2.4%yr). Cost-of-living measures, most notably the various state and federal government energy rebates, played an important role in suppressing headline inflation, with electricity prices falling –9.9% (–25.2%yr). That said, inflationary pressures are abating broadly across the consumer basket. Most notably in the housing group, including rents and homebuilding costs, but also across fuel, clothing/footwear and household contents/services. Price pressures are still showing persistence in a few sub groups though. While total services inflation ticked down at year-end (4.6%yr in Q3 to 4.3%yr in Q4), downward revisions to childcare costs were at play. The narrower market services inflation measure continues to hover just north of 4.0%yr, with increases in holiday travel and insurance costs primary supports.
Encouragingly though, the RBA’s preferred gauge of underlying inflation, trimmed mean core inflation, eased from 3.6%yr to 3.2%yr Q3 to Q4, and is now tracking a six-month annualised pace of just 2.7%yr, inside the RBA’s 2-3%yr target range. As outlined by Chief Economist Luci Ellis, this update shifts the balance of risks for policy. Although the full suite of economic data is giving mixed signals on the strength and capacity of the economy – consumer spending has disappointed following the Stage 3 tax cuts but we continue to observe a tight labour market and (modest) real income gains – on balance, we believe the inflation trend warrants an imminent start to rate cuts. We have now returned to our earlier view that, starting in February, the RBA will undertake a gradual easing cycle of 25bps per quarter through Q4 to a terminal rate of 3.35%.
Offshore, it was a busy week of central bank meetings and key data.
The FOMC kept rates steady in January having cut by 100bps through late-2024 to a fed funds rate of 4.375%. Meeting communications suggest the Committee remains constructive on the health of the economy and believe the disinflationary trend will persist, with the labour market seen as broadly in balance and an increase in slack judged unnecessary for inflation to continue to decelerate through 2025 as monetary policy remains restrictive.
Of the US data released this week, Q4 GDP stands out. Domestic final demand had another strong quarter, growing 3.0% annualised, in line with the average of the prior three quarters. Household consumption drove this result, backing up Q3's strong 3.7% annualised gain with a 4.2% result in Q4, principally on strength in services consumption though growth in goods consumption was also robust. Government spending meanwhile continued to contribute to GDP at both the Federal and state & local levels, and housing investment rebounded after six months of declines. Business investment was weak however, equipment investment falling at a 7.8% annualised pace (admittedly likely weighed down by industrial disputes) while structures activity declined 1.1% annualised.
The composition of growth matters greatly for the outlook. The labour market and the average US household’s long-term fixed borrowing costs should continue to insulate discretionary consumption. But the sharp rise in long-term yields since last September owing to inflation risks from tariffs and immigration changes and a general expectation of persistence in fiscal expansion casts a long shadow over the housing sector – evincing the risk, pending home sales fell 5.5% in December. While President Trump intends to spark private investment across the US by imposing tariffs and through measures like the AI infrastructure initiative announced last week, this is not necessarily a given, particularly in the near term.
With President Trump today confirming that 25% tariffs will be imposed on imports from Canada and Mexico and that the administration is currently considering actions against China, the coming weeks and months will be a good test of the responsiveness of the US economy to these policies, in particular which way the risks for investment and employment will skew. For the FOMC, the implications of these policies for activity matter as much as for inflation.
For Canada, the balance of risks are certainly one sided, although their scale will depend on whether oil exports to the US escape the 25% tariff. The potential implications of US policy were certainly on the minds of the Bank of Canada as it cut its overnight rate by 25bps to 3.0% and called an end to quantitative tightening, the BoC believing that balance sheet normalisation is largely complete. Arguably the market was more intrigued by the absence of forward guidance for policy, the statement and Governor Macklem’s remarks making clear January’s projections were "subject to more-than-usual uncertainty" given the "rapidly evolving policy landscape". Cumulative rate cuts to date are providing support to Canada’s economy, job growth and household demand are picking up, but with the labour market still soft overall, the announced tariffs put at risk the absorption of excess supply in Canada’s economy anticipated by the BoC over the next two years while also threatening their ability to meet the inflation target, and arguably the ability of monetary policy to provide meaningful additional support to the economy.
The European Central Bank also cut rates by 25bps at their January meeting. The statement and press conference signalled greater concern over the persistence and breadth of the growth upturn, unsurprising given the just released Q4 GDP report suggests activity contracted in Germany and France into year end and stalled across the Euro Area overall – Spain providing an offset, growing 0.8% in Q4. It is also worth noting that the stance of policy and financial conditions were characterised as "restrictive" and "tight" respectively, pointing to additional downside risks for the Euro Area economy in addition to those emanating from US trade policy. To our expectation of two more cuts from here, the market sees downside risk. The policy outlook will depend on the extent to which the easing undertaken to date bolsters confidence amongst households and firms’ resolve to work through the considerable challenges they face.
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