Analysts are split between whether official interest rates in most major economies, including in Australia, have peaked or need to be tweaked a little higher. The US Federal Reserve in the minutes of its last policy meeting indicated that inflation and recession risks are balanced, an indication that its Funds rate is at a peak at 5.50%. The minutes of the RBA’s October policy meeting, the first presided over by new Governor, Michelle Bullock, will be released tomorrow and are likely to be more cautious in tone than the US Fed’s minutes, indicating inflation is slowing, but still too high, so a higher cash rate may still be needed.

Both the Fed and the RBA are watching the data to see if they have reasonable hope of reining inflation down to their targets over the next 18 months or so. If the data over the next few months show high risk of persistently high inflation a second phase of rate hikes may be needed from the Fed and possibly the RBA taking official interest rates higher than analysts or the market are expecting in the first half of 2024.

Essentially, the central banks have been using higher official interest rates and tighter monetary conditions to temper growth in household spending. Pull back demand and travel down the upward sloping supply curve for goods and services and basic supply and demand dynamics mean reduced price pressure.

One problem the central banks have faced is that supply, mostly of goods but also of services, has been disrupted from time to time during the global pandemic. The supply curve for goods and services has shifted inwards meaning that for any given level of demand the price is higher. At times, the central banks have been facing and trying to combat unusually strong “demand-pull” inflation pressure responsible for pushing up inflation rates to their highest levels since the 1980s and requiring a particularly brutal monetary policy response to reduce demand pressures and in turn inflation.

Resolution of some goods global supply chain problems as well as slowing demand responding to tighter monetary conditions has thrown some price pressures in to reverse over the past year accounting for a relatively sharp pull-back in annual inflation from mid-2022 to mid-2023 in the case of the US and from late-2022 to mid-2023 here in Australia. That largely goods-price inspired reduction in inflation, at one point down to 3% (headline CPI) in the US and below 5% here in Australia, allowed both the US Fed and the RBA to pause and take stock of the incoming data and assess whether demand growth is slowing enough to wind down inflation towards their respective targets.

The answer is teetering on the edge. The latest US September CPI reading shows the monthly reading at 0.4% m-o-m, slightly higher than widely expected and holding the annual inflation rate at 3.7% y-o-y confirming the upward blip in inflation since the mid-year low 3.0%. Sticky service prices and higher energy prices have underpinned recent monthly CPI increases (0.4% in September and 0.6% in August) which if repeated over the next few months would push US inflation well above 4% y-o-y by early-2024.

Very tight US labour market conditions with the latest September gain in non-farm payrolls above 300,000 and wage growth still north of 4% y-o-y point to waning progress slowing demand and mounting risk of “cost-push” inflation.

US inflation and the labour market could be on a final strong blip before tight monetary conditions cut in harder. Monetary policy change works with a notoriously long and variable lag. Given the record extent of rate hikes in the US from zero to 5.50% it is reasonable to expect much softer demand conditions to set in over the next 12 months.

However, the longer sticky inflation, tight labour market conditions and relatively firm demand persist, the greater the pressure on the Fed to resume monetary policy tightening and after a pause of a few months that means not just one hike, but a second phase of hikes to make sure that demand, the labour market and inflation are pushed on a sustainable path lower.

In Australia, there is also a risk that a second phase of monetary policy tightening may be required although not as great a risk as in the US. Household spending growth in Australia has moderated more in Australia than in the US to higher official interest rates, even though the Australian official cash rate has risen relatively less than in the US.

Australia’s predominantly variable interest rate home loan market set against the US long-term fixed-rate home loan market has meant that Australian household disposable income after contractual interest rate commitments has come under much more pressure from rising official interest rates.

Inflation is higher in Australia than in the US and labour market conditions are about as tight, but demand is weakening more in Australia than the US providing more reason to expect that labour market strength and inflation will moderate over the next few months.

However, if the data stays relatively firm, the RBA will be forced to accept that high inflation is persistent and needs a second phase of rate hikes. Like in the US, it is the months of rate pause that dictates the need for more than just one rate hike, two or three more hikes at least.

In conclusion, the US Fed and the RBA both need several months of data to assess whether inflation is returning to a downward trajectory towards their targets. If those data reads indicate a resumption of the downward trajectory official interest can stay on protracted hold ahead of some easing late-2024 or early 2025. But there is also a material possibility that inflation remains sticky and if that possibility firms in data reports over the next few months the US Fed and possibly the RBA will need to deliver a second phase (two or three hikes) taking the Fed funds rate above 6.00% and the RBA’s cash rate close to 5.00% in the first half of 2024.