There have been twists and turns aplenty in the outlook for the global and Australian economies so far this year. Stronger for longer with central banks behind the curve tackling inflation, gave ground to central banks fighting to catch up with aggressive rate hikes prompting recession and now inflation is beaten so central banks can be less aggressive on the monetary brakes and the recession risk is fading.

Around these main changes in analysts’ views of the economic outlook are a liberal sprinkling of factors that could torpedo economic forecasts – China’s property construction crisis and Covid containment policy; the Ukraine War; Covid-related supply chain disruption meeting pent-up demand; labour shortages almost everywhere; and climate-change disruption, just to name a few.

In this highly uncertain economic environment, another twist may be in the making. Essentially, it involves how central banks react as annual inflation retreats sharply from its peak in the US and over the next few months here in Australia as well. There is a risk, probably a greater risk for the US Fed than the RBA, that they do not hike their respective official interest rates enough over the remainder of this year paving the way for a second round of rate hikes later next year when it becomes clear that the base for annual inflation is settling above the Fed’s and RBA’s inflation targets.

The possibility of a two-phase rate hiking cycle in the US and maybe here comes about only if the Fed and RBA pause the current rate-hiking cycle before reaching what might be considered neutral or normal official interest rates.

In the US, where tight labour market conditions are generating 5%+ y-o-y wage growth the Fed should go a little higher than neutral to rein back inflation to its 2% target over time. For Australia, with wage growth lower than in the US – the Q2 wage price index out on Wednesday may show annual wage growth around 2.7% y-o-y – the RBA can probably get inflation back to 2-3% target band over time by taking the cash rate to neutral.

At the July policy meeting the Fed hiked the funds rate 75bps to 2.50% while at the early August policy meeting the RBA hiked the cash rate 50bps to 1.85%. Both central banks indicated willingness to continue hiking to contain inflation but also a sensitivity to incoming data and what it showed relating to growth and inflation.

Our view is that the neutral official interest rate for the US around 3.00 to 3.50% is higher than for Australia, around 2.50 to 3.00%. Also, as mentioned earlier, US labour market conditions are materially tighter than in Australia implying that the Fed needs to hike rates beyond neutral, to say around 4.00%. If the current Fed and RBA rate hiking cycle fail to reach respectively 4.00% and 2.60%ish, before the two central banks pack their bags for a lengthy pause, demand growth in both the US and Australian economies is unlikely to be contained enough to allow annual inflation to fall sufficiently over time sowing the seeds for a second rate-hiking cycle later next year.

At present, the risk of the Fed and RBA stopping short of where they need to hike rates over the next few months is perhaps not great, although rallying financial markets are taking a view that central banks are all but done. What is driving their view is peaking US annual inflation and the slide in prospect. They are banking that falling inflation will lead the Fed to brake less hard and soon not at all.

Annual inflation in the US and in Australia was always destined to have a period of sharp retreat starting mid-2022 in the US and a few months later in Australia because of the key early drivers of high inflation in 2021and early-2022, very large increases in food and petrol prices and to a lesser degree goods prices. Food, petrol and goods prices over the past month or two are rising at lower pace, stabilising and in some cases falling sharply cutting big chunks out of the annual inflation even as prices for some other categories within the CPI are still rising.

In the US, the July CPI reading moderated more than widely expected showing no rise month-on-month and reducing the annual inflation rate to 8.5% y-o-y from 9.1% y-o-y. Given that monthly US CPI readings were very high through the second half of 2021 there is a strong likelihood that US annual CPI inflation readings will fall much lower over the remaining months of this year towards 5.0% by year-end, but with progress lower slowing before reversing towards mid-2023.

Does the Fed cite the rapid reduction in inflation over the next few months as cause to slow and end interest rate hikes before reaching neutral around 4.0%? We believe that it shouldn’t, but it may.

The RBA may be presented with less cause than the Fed to slow rate hikes in the near term. While Australian annual wage growth is running at much lower pace than in the US, the wage price index reading this week is likely to show accelerating annual wage growth, albeit to only 2.7%, but wage growth that is certain to accelerate in Q3 after the 5.2% rise in the minimum wage effective from 1 July.

The July labour force report out on Thursday is expected to show the labour market still very tight with the unemployment rate holding down at a 48-year low 3.5%. Q2 GDP growth due out the day after the next RBA policy meeting in early September, is expected to be strong boosted by big contributions to growth from household consumption spending (real retail sales rose 1.4% q-o-q in Q2) and net exports (the nominal international trade surplus increased $A18 billion in Q2).

Also, Australia’s annual CPI inflation rate is yet to peak, although falling petrol prices and fast reducing food prices imply a peak less than 7.8% y-o-y in the RBA’s latest forecasts and in Q3 rather than Q4.

A two-phase rate hiking scenario seems less likely for the RBA than the Fed, but the RBA still needs to deliver hikes to the tune of 75bps over the next two or three policy meetings to avoid inflation settling too high through 2023 and 2024. Will the Fed and RBA stop short of delivering official rate structures sufficient to anchor inflation medium-to-longer term? The answer will come from the hikes (or lack of) delivered over the next two or three policy meetings.