Cliff Notes: fear overwhelms
Key insights from the week that was.
Among the plethora of major central bank decisions this week, the RBA stood out from the pack, delivering a 25bp rate hike which took the cash rate to 4.10%. The widely expected decision was finely balanced in the end, the 5-4 split vote coming down to a difference in opinion over timing – the minority believing they had the opportunity to assess more data before acting.
In the press conference, Governor Bullock made clear that the decision was driven by the Board’s assessment of the starting point for inflation, which is “already too high”, and capacity developments, “the labour market ha[ving] tightened a little recently and [with] capacity pressures… slightly greater than previously assessed”. The conflict in the Middle East is also adding to near-term price pressures and uncertainty. In this week’s video update, Chief Economist Luci Ellis discusses these points in more detail. We continue to expect another 25bp hike in May, and the market sees a risk of further tightening before year end.
The RBA decision provided an interesting backdrop for the latest labour force survey which surprised on two fronts. Firstly, employment growth was firmer than expected, the 48.9k gain in February lifting the three-month average growth pace above its likely nadir, from 1.0%yr to 1.3%yr. Increased participation also lifted the unemployment rate to 4.3% in February after two months at 4.1%. We previously flagged the risk of a turnaround in participation lifting the unemployment rate. Assuming this turn persists in coming months, December/ January will be seen as a display of weaker labour force participation temporarily compressing the unemployment rate rather than a meaningful ‘re-tightening’.
Before moving offshore, it is worth emphasising that, while higher fuel prices were “not the reason” for the RBA’s March rate hike, the Middle East conflict was assessed to have skewed the risk profile for inflation to the upside, both in the near-term via global energy prices and “further out” should supply capacity be impacted, or inflation expectations increase materially. While the RBA have not yet modelled the impact in detail, our scenario analysis and deep-dive into Australia’s exposure to energy price shocks provides the structure around our current thinking.
In the US, while the FOMC recognised the increase in global uncertainty since January, their focus remained on the domestic economy. GDP growth is now expected to be 2.4% in 2026 (prev. 2.3%) and, more significantly, 2.3% in 2027 (prev. 2.0%), then 2.1% in 2028 (prev. 1.9%), growth benefitting from productivity versus a stronger labour market. The consequences for inflation of tariffs and the Middle East conflict are, in contrast, seen as temporary, annual inflation revised up 0.3ppts to 2.7% for 2026 but only edged higher in 2027 to 2.2% and unchanged at 2.0% in 2028. Capacity constraints evident in the US economy (housing and energy are prime examples) continue to get little airplay in the FOMC’s communications, so too the potential for second-round effects from energy and other commodities impacted by the conflict in the Middle East (fertiliser being an example). Inflation expectations are clearly not a concern for the FOMC, in stark contrast to the RBA’s view for Australia.
The Committee's base case for the stance of policy therefore remains one cut in 2026 and another in 2027 to 3.1%, which is now members’ best estimate of the US’ longer run neutral rate. Westpac continues to believe that the FOMC are, at most, likely to cut once more in this cycle. The lack of private sector job creation spoken about in the press conference points to the timing of this cut being sooner than later. We have this decision pencilled in for June, albeit with low conviction. The more critical point here though is that, with economic and fiscal capacity constrained as well as potential upside risks from tariffs and commodities, term US yields are likely to rise from here.
The global energy price shock meanwhile brought greater unity among policymakers at the Bank of England. Having previously voted to cut Bank Rate by the narrowest of margins in February, in March the Monetary Policy Committee unanimously opted to maintain the policy rate at 3.75%. Both the policy summary and meeting minutes emphasised the ongoing conflict in the Middle East and its repercussions for UK inflation. The committee remains particularly vigilant for any indications of domestic inflationary pressures emerging through second-round effects, though they also acknowledged the implications for inflation from weakening economic activity. In the minutes, MPC members noted that the policy stance has shifted from considering rate cuts towards the possibility of hikes, with concerns about higher inflation outweighing downside risks to growth. Even the most dovish members now appear open to the prospect of a rate hike. Fearing the duration of the current conflict, the market has priced more than two hikes before year end.
Across in Europe, the ECB Governing Council unanimously voted to keep interest rates unchanged, with the deposit rate remaining at 2.0%. The policy statement highlighted that the outlook has become considerably more uncertain due to the Middle East conflict, yet maintained a balanced tone, noting that “monetary policy is well positioned to navigate this uncertainty”. President Lagarde argued during the press conference that the economy is in a stronger position compared to the 2022 energy shock, and the ECB is better equipped to assess the impact of shocks.
Previously, the ECB expected euro area inflation to be slightly below 2% in 2026 and 2027. Now, the ECB forecasts inflation to peak at 3.1%yr in Q2 and average 2.6%yr for this calendar year. However, these projections are based on financial market variables, including oil and gas prices, as of 11 March which current spot prices materially exceed. Helpfully, the ECB also released stress scenarios that assume more severe energy supply disruptions via the Strait of Hormuz and higher energy prices.
In their ‘adverse scenario’ – which appears closer to current experience – the ECB sees inflation at 3.5%yr for this year, while in the ‘severe scenario’ the ECB’s modelling suggest it could rise as high as 4.4%yr and remain well above target through 2027. The impact on GDP growth appears to be more manageable, but still significant. Under the baseline scenario, 2026 growth is expected to be 0.9%yr, down from 1.2%yr forecast three months ago. It would be 0.3ppt and 0.5ppt lower in the adverse and severe stress scenarios, respectively. As for inflation, under severe, the hit to GDP extends through 2027. The lesson to take from this scenario analysis is not the point estimates themselves, but rather that the impact on both inflation and growth of a loss of supply becomes increasingly non-linear as the duration of the crisis lengthens, as second round and confidence effects are felt. The risk to inflation expectations means that most central banks will initially be focused on price uncertainty near term, then the downside risks for activity as they appear – more so in 2027 than 2026.
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