Global economic growth was resilient in the face of the Omicron wave in February but with high inflation a threat to growth prospects. Central banks are talking tougher in terms of quick removal of unconventional monetary policy support, but most have not started to lift emergency-low official interest rates and when they do start are indicating a slow passage back to normal or neutral interest rate settings. The Omicron wave is fast subsiding reducing one threat to global growth prospects, but the outbreak of war in the Ukraine with its attendant risk of a wider European and global conflict presents risks of lower global growth and higher inflation.  

The US economy showed mostly strong signs through February. Q4 2021 GDP was revised higher to 7.0% annualised growth with strong contributions to growth from private consumption and investment spending. Early in Q1 2022 the economy continued to grow jobs fast with non-farm payrolls up 467,000 in January after gaining 510,000 on revision in December. Retail sales, reduced by the Omicron wave in December, rebounded more sharply than expected in January, lifting by 3.8% m-o-m.

Strong spending in the US continues to place pressure on prices. While supply chain bottlenecks are starting to ease strong demand supported by high wage growth above 5% y-o-y on all measures means the current high inflation peak is proving slow to pass. Annual CPI inflation lifted to 7.5% y-o-y in January from 7.0% in December, while annual factory gate or producer price inflation in January edged down slightly to 9.7% y-o-y from 9.8% in December but on a January-month read of 1.0% m-o-m indicates a peak ahead and above 10.0% y-o-y.

Rising US wage growth also means that whatever the reduction in annual inflation later this year – possibly substantial reduction give that higher goods and energy prices are contributing more than half of the current high annual inflation rate – higher annual inflation will return in 2023 and at an annual rate well above the Fed’s target of 2%. Reading through the roller-coaster annual inflation pattern over the next year the average annual inflation rate will be 3%+ and will be rising in 2023.

The high inflation outlook implies that the Fed will be hiking the current 0-0.25% Fed funds rate and several times this year, starting the process in March. The US bond market is starting to factor in Fed monetary tightening, including the Fed turning from net buyer to net seller of bonds. The bond market is also likely to factor in a realistic assessment of medium-to-longer term US inflation which alone implies the US 10-year bond yield moving above 3.00% over the next year.

Turning to China, February has been a quiet month for data with the lunar New Year celebrations. The few data and survey releases indicate that China’s economic growth rate is still slowing making China a significant odd man out from mostly strong economic growth readings in other major economies. Official January purchasing manager reports showed slippage in both the manufacturing and non-manufacturing PMIs to respectively 50.1 (50.3 in December) and 51.1 (52.7 in December) while the Caixin PMI surveys showed manufacturing slipping below the 50 expansion/contraction line at 49.1 (50.9 in December) and non-manufacturing down to 51.4 (53.1 in December). Slowing growth is helping to contain consumer price inflation, down to 0.9% y-o-y in January from 1.5% in December providing the Peoples’ Bank of China with the flexibility to ease monetary conditions. There are also signs that the Government is instructing local authorities to accelerate selective infrastructure spending to help offset damage to property companies and spending resulting from earlier Government directives aimed at reining in excess. More expansionary policy settings mean China’s GDP growth rate should accelerate this year, albeit off a low base in late 2021 and early 2022.

Europe will be affected most by war in Ukraine, but the extent of those effects will be determined by how or if the crisis escalates. As it stands, a period of higher energy and food prices as well as the costs of economic sanctions against Russia and the humanitarian refugee crisis will dampen Europe’s growth prospects while lifting already high inflation (5.1% y-o-y in January with producer price inflation above 26% y-o-y). Europe’s unemployment rate at 7.0% is the lowest it has been since the establishment of the Euro currency in 1999 and is much lower, near 3%, in Europe’s powerhouse economy, Germany. Abstracting from the Ukraine war, European economic indicators point to strong growth accelerating adding to demand pressure on prices just as the Ukraine conflict adds, hopefully only temporarily, to supply chain problems. High European inflation looks set to rise higher, but the European Central Bank (ECB) remains on hold concerned by potential downside risks to growth. ECB reluctance to start  normalising ultra-low official interest rates increases the risk of entrenched high European inflation requiring greater lift in official interest and probably European bond yields later in 2022 and beyond.

In Australia, a strong Q4 GDP reading on Wednesday is on the cards. The household sector spent up a storm in Q4 with real retail sales up a record 8.2% q-o-q. Retail sales comprise most of household consumption spending which in turn constitutes more than 60% of spending on GDP. Very strong household consumption spending in Q4 should underpin a GDP rise of at least 2.5% q-o-q. Turning to early Q1, household spending is being provided a further boost with the rapidly slowing Omicron wave and associated lifting of restrictions. Households are fit to spend more aided by strong employment growth, a 15-year low 4.2% unemployment rate in January, plus a large savings buffer built up from government largesse and restricted spending opportunities during the worst phases of the pandemic.

Another factor boosting Australian national income is high commodity prices. Market expectations that commodity prices might retreat in 2022 are turning to the possibilty of further selective price increases because of the Ukraine War. As far as household income growth is concerned, wages are rising slowly (Q4 2021 wage price index +0.7% q-o-q, +2.3% y-o-y) and the Federal Government will bring down a pre-election Budget in late-March likely to cement growth in after-tax household income.

As the RBA forecast in its February Monetary Policy Statement, Australian real GDP growth is likely to be strong in the first half of 2022, 5% y-o-y in Q2 and well above 2.7% long-term trend growth. As a result of strong growth, the unemployment rate will fall to 3.75% by end-2022 according to the RBA but in our view nearer to 3.0%. In either case, the unemployment rate is falling to levels not seen since the early 1970s. It is reasonable to assume that wage growth will accelerate. The 0.7% q-o-q wage price index result in Q4 2021 will lift to 0.8% q-o-q and above each quarter in 2022 and annual wage growth will rise above 3% y-o-y and possibly above 4%.

Tightening labour market pressure may be alleviated a little by the opening of the borders to international workers, but at best that may limit the extent that wage growth accelerates. Annual wage growth will still be ample to underpin annual inflation in the higher part of the RBA’s 2-3% target band and possibly above throughout 2022 and 2023. Annual CPI inflation was at 3.5% y-o-y in Q4 2021 with trimmed mean (underlying inflation) at 2.6% y-o-y. Both will be higher again when Q1 2022 inflation readings are released in late April.

Strong underpinnings of Australian economic growth, the tightening labour market plus continuing near-term factors supporting higher inflation are likely to pressure the RBA to start hiking the official cash rate possibly starting in May but more likely in August. Ultimately, the RBA will need to lift the cash rate to at least 2.50%, but the path to that more neutral cash rate is hard to predict. At this stage we expect the cash rate to be 0.75% at the end of 2022 and 1.75% by the end of 2023.