We view early 2022 as a make-or-break period for the world’s major economies, including the Australian economy. Most major economies are leaving 2021 and entering 2022 with strong growth momentum built largely on the highly stimulatory policy settings of most governments and central banks. Where policy stimulus is starting to be wound back the process is modest so far and unusually modest in the case of central banks already presiding over above-target inflation.
Based on what various senior Fed officials have been saying recently, including recently re-appointed Chairman, Jerome Powell, the markets are probably right in their assumption that the Fed will stay dovish in the near-term. While throughout 2021 the Fed has serially under-forecast the rise in US inflation and admits that the rise in inflation can no longer be considered transitory, the Fed is giving no signals that it is about to start fighting the rise in inflation.
Instead, the Fed is slowly reducing its super-stimulatory bond buying program and leaving in place a Federal Funds rate that on historic real basis has moved from –6.1% based on the October CPI to –6.7% on the November CPI. The dial on US monetary policy is set firmly on priming stronger demand and higher inflation. US budgetary policy remains highly expansionary too with massive multi-year spending totaling near $US4 trillion on hard and social infrastructure in the wings.
Meanwhile, high US demand supported by rising employment, wages and household wealth as well as highly supportive monetary and fiscal policy settings is still running up against constrained supply. While high annual US inflation may step down on some pull-back in month-to-month CPI readings over the next few months, everything else, especially policy settings, are pointing to higher annual US inflation longer-term.
At some point, the Fed will have little option but to tackle inflation that has risen too high. Whether it is 7, 8, or 9 handle on the annual inflation rate that turns the Fed from dove to hawk is hard to say. What is clear is that more alarming US annual inflation rates are becoming more likely at some point in 2022 and it is reasonable to expect that the Fed will be forced from delaying rate hikes to trying to catch up and starting early in 2022.
In Australia, inflation pressure is building at lesser pace than in the US. Annual CPI inflation is at the top of the RBA’s target range at 3.0% y-o-y in Q3 2021. It is likely to lift above 3.0% in Q4 and stay well above 3% in Q1 2022. Even if there is a brief base-effect dip in annual inflation beyond Q1, current economic policy settings – a cash rate at 0.10% (-2.9% in real terms) plus plenty of government spending in a pre-election March budget – all but guarantee a renewed push higher in annual inflation in late 2022. Expansionary policy settings adding fuel to the strong rebound in household and business spending post-lockdowns will generate strong demand-pull inflation pressure late-2022 moving into 2023 that could see annual CPI inflation with a 4 handle and possibly even higher.
Annual CPI inflation undulating through high 2% mid-2022 to low 4% early-2023 will test the patience of the RBA. It will challenge its view that there is no permanently higher inflation until wages rise above 3% y-o-y. Instead, it is likely to become clearer that demand-pull inflation will eventually generate the higher wages growth that reinforces the rise inflation unless there is a policy change circuit-breaker.
At some point in 2022 we see the RBA changing from dove to hawk on inflation. The conversion will be later than the US Fed’s conversion prompted by 1980s-style US inflation readings forcing it to start hiking rates probably in Q1 2022. The RBA may be able to hold out until the second half of 2022 before starting to hike rates.
The Fed and the RBA have spent 2021 furiously stoking demand and inflation. Their in-house economic forecasts throughout the year have fallen short of predicting the demand and inflation generated. It has almost been a surprise to them what they have helped to unleash. Now they have mounting evidence that ultra-easy monetary policy left in place too long during economic recovery and one beset by supply challenges will generate high inflation.
Central bank policy credibility is increasingly at stake if their inflation forecasts keep under-shooting during 2022. The risk of losing credibility makes the remaining central bank doves from 2021 an endangered species in 2022.
As the doves turn to hawks, we expect the US Fed to hike rates three times in 2022 taking the funds rate to 1.00% by year-end. We expect the RBA to hike rates twice in 2022. The first hike is likely to be small, probably 0.15bps taking the cash rate to 0.25% in July or August. We pencil in a second 25bps hike to 0.50% in Q4 2022.
Government and central bank policy dials are still set to support growth. In the US, the Federal Reserve (Fed) took a hawkish turn at its December policy meeting after November inflation reports that showed annual CPI inflation the highest since 1982 at 6.8% y-o-y with producer price inflation at 9.8% y-o-y. The policy response by the Fed to US inflation that is now high and proving to be entrenched with every passing month is minimal. The Fed will taper bond-buying stimulus faster but will wait a few more months before starting to hike the Funds rate currently at an emergency, deflation-fighting low 0-0.25%.
Even when the Fed does start to hike the Funds rate it indicates a series of small increases rather than an aggressive inflation fighting response. At its December meeting the Fed forecast three 25bps hikes to the Fed Funds rate to 1.00% by the end of 2022 with further increases over the following two years taking the rate to 2.50%. At this stage, the Fed’s planned rate hikes starting late to tackle a high inflation problem that has been building through 2021 do not lift close to matching inflation over the next three years. The real Federal Funds rate stays deeply negative presenting little headwind to growth or inflation.
All else being equal, the Fed’s delay before starting to hike all but guarantees a combination of strong growth and high inflation in the first half of 2022, a scenario for growing US company profits, albeit not at the same stellar pace set in 2021.
Of course, things can change rapidly. The ever-changing and highly unpredictable permutations of the Covid pandemic can still pitch a curve ball into any forecasts.
The latest Omikron variant seems to produce less severe illness and on the face of it means lower hospitalisation and deaths. But it is also much more infectious than previous variants and sheer numbers of infections can lift hospitalisation rates to crisis levels requiring a return to growth-crimping restrictions.
One thing we have learned in 2020 and 2021 is that a microscopic virus and its ability to keep changing can thwart human genius to contain it and consign the best of economic forecasts to the garbage can.
Perhaps a more predictable change over the next few months is that what central bankers are saying about policy change now will almost certainly change as circumstances dictate. In the case of the US Fed, it has changed position through 2021 from no rate hikes before 2024 to now calling three rates in 2022 with more in 2023. Barring a return to widespread pandemic restrictions, baked-in high monthly US inflation readings in December and January mean the Fed could become more hawkish, perhaps leading off with a 50bps rate hike in March with rate hikes each meeting beyond taking the Funds rate to 1.50% or higher by the end of 2022.
Alternatively, the Fed might choose to try and stare down high inflation readings either sticking to its December rate guidance or even delaying rate hikes if growth comes under renewed pandemic restriction threat.
Very cautiously, we lean towards the likelihood that the Fed’s December meeting rate guidance is the minimum it will deliver in 2022 and we expect high December and January US inflation readings to cause the Fed to become more hawkish on rates in March.
Turning to the RBA, it has become less dovish over recent months and has withdrawn guidance of no rate hike before 2024 at earliest, to no conditions for a rate hike in 2022, but some possibility in 2023. The RBA is on firmer ground holding out against a near-term rate hike than its central bank peers internationally. Australian upward inflation pressure has been lower so far than in North America, Europe or across the ditch in New Zealand.
Inflation pressure from energy prices is less pronounced in Australia than elsewhere. Wages have not risen as fast in Australia so far. However, supply chain problems are as pronounced in Australia as they are overseas and Australian demand is being primed strongly. Limited supply of goods meeting strong demand increases the likelihood of upside CPI surprises, including the current Q4 reading due out in late January.
Low wage growth is unlikely to continue either. While an element of low wage growth continues because of the pattern of multi-year enterprise bargaining agreements, wages outside these arrangements are responding quickly to high labour demand and low supply. The RBA sees the return of international workers helping to lift supply although the omicron curve ball and evidence of considerable delay processing visas to enter Australia hint that additional labour supply may come well in arrears of labour demand already vaulting to the heavens.
It is now highly likely that the wage price index for the current Q4 quarter, due in mid-February will show a q-o-q increase of 0.8% or higher (annualising close to 3%). The Q1 2022 wage price index out in mid-May seems set to run at least 1.0% q-o-q (4% annualised).
Between late-January and mid-May 2022 we see Q1 and Q2 CPI and wage price index releases that will challenge the RBA’s view that inflation is not running consistently and sustainably above 2-3% target band. While the RBA will try and stay “patient” in its words, we expect that patience to wear very thin by mid-2022 and we expect an initial rate hike in July or August.
We see data reports early in 2022 in the US and Australia, particularly inflation reports, accelerating the more hawkish/less dovish turns by the Fed and the RBA in late 2021. The increasing threat of a return to more normal interest rate settings will add to financial market volatility and place a gentle brake on economic growth prospects. However, forecasting is subject to more caveats than usual in an era of unpredictable pandemic forces as well as with inflation on the rise for the first time in three decades.
Wishing our readers seasonal best wishes and a happy and prosperous 2022. The next report will be on Monday 10th January 2022.