High inflation and central banks starting to front-load monetary policy in response brought the prospect of recession into sharper focus in June even though current data readings still show firm economic growth. Inflation is proving slow to peak challenging central banks and making it more difficult to dial a soft economic landing, even in countries where economic growth is firmly underpinned such as the US and Australia. Previously pumped-up demand to deal with the growth crunch from the pandemic in 2020 and 2021 continues to run well ahead of limited supply. Disruption to supply chains has worsened with the Ukraine War and China’s shutdowns dealing with Omicron. Central banks in May and June have started to admit that they are now actively working to contain demand growth to match limited growth in supply of goods and services.

In the US, the Federal Reserve at its June policy meeting stepped up the pace of withdrawing monetary support and hiked the Funds rate by 75bps to 1.75%, the biggest lift in the Funds rate in 22 years and coming after a 50bps hike at its May meeting. Fed Chairman, Jerome Powell, promised more large rate hikes to tackle inflation and the Funds rate based on the forecasts of Fed Governors and Presidents is forecast to lift to 3.80% in the first half of 2023. The US economy in the early stages of the Fed’s aggressive rate hikes remains strong.

Leading economic indicators such as the ISM manufacturing and non-manufacturing indexes at respectively 56.1 and 55.9 in May are in expansionary territory. Consumer sentiment has weakened but retail sales are firm and May nonfarm payrolls, up 390,000 with the unemployment rate at 3.6% show a tight labour market still generating annual wage growth above 5% y-o-y. There are some signs of softness in US housing activity, although the latest new home sales for May were up 10.7% m-o-m.

US economic growth resilience is a mixed blessing with inflation running high. The CPI rose 1.0% m-o-m, 8.6% y-o-y in May, up from 0.3% m-o-m, 8.3% y-o-y in April. High inflation extends beyond the big increases in food and energy prices and the core CPI, excluding food and energy prices, rose in May by 0.6% m-o-m, 6.0% y-o-y. Producer prices rose 0.8%, 10.9% y-o-y implying higher CPI inflation in the pipeline.  High inflation over the next few months implies more big Fed rate hikes and the possibility that the peak Funds rate is higher than the Fed is forecasting currently. The risk is growing of high interest rates tipping the US economy into recession down the track.

In China, the data for May although not as weak as in April show an economy that probably slipped to negative GDP growth in Q2. The firmest part of China’s economy in May was international trade with exports up 16.9% y-o-y from 3.9% in April and imports up 4.1% y-o-y from flat in April. May indicators of domestic spending and output were still soft. Growth in fixed asset investment moderated to 6.2% y-o-y in May from 6.8% in April. Industrial production improved to +0.7% y-o-y from –2.9% in April while retail sales fell 6.7% y-o-y, not as bad as the 11.1% y-o-y fall recorded in April. China’s zero-covid policies dealing with the Omicron outbreak are still crimping spending although restrictions are starting to ease. Official spending programs are ramping up to lift economic activity before the key Peoples’ Congress meetings in November slated to affirm President Xi’s next 5-year leadership tenure. Policy directives and nudges  mean that China’s GDP growth rate should lift through the second half of 2022 but at modest pace given headwinds from moderating global growth and lingering issues related to Omicron control and the weak property development sector in China.

Europe continues to show relatively strong past economic data but is at greatest risk of sliding into recession because of restricted energy supply and high prices from Ukraine War sanctions against Russia. Europe’s inflation rate is high and rising. CPI inflation rose to 8.1% y-o-y in May from 7.4% in April and producer price inflation at 37.2% y-o-y in April implies much higher CPI inflation in coming months. The European Central Bank, caught between prospective slowing in European GDP growth and very high inflation, has opted to go slowly withdrawing monetary support. It has stopped buying bonds but has yet to hike official interest rates. The ECB deposit rate remains unjustifiably low in the current high inflation climate at –0.50%. The ECB has indicated that it will hike rates at its next policy meeting. In Britain, the Bank of England dealing with CPI inflation that has pushed above 9% y-o-y has hiked rates five times, although its latest 25bps hike was smaller than expected and reflects concern that British economic growth is fast losing altitude.

In Australia, the RBA became more hawkish about the local inflation outlook during June. At its policy meeting in early June, it hiked the cash rate by 50bps to 0.85% and indicated a more rapid return of the cash rate to normal setting currently nominated by the RBA around 2.50%. The RBA admitted that it had been blind-sided by the rapid inflation rise and it now expects inflation to rise to around 7% by the end of 2022 before easing in 2023. Factors driving higher than expected inflation include the stronger than expected recovery in the Australian economy, the slow resolution of supply chain problems intensified by China’s shutdowns in response to Omicron and the recent additions to food and energy prices from disruptions related to the Ukraine War.

The RBA recognises that Australian demand growth is running too strongly allowing for supply constraints and factors such as the build-up of household savings during the pandemic and the tightness of the labour market coming out of the pandemic mean that the Australian economy should remain relatively resilient in the face of rising interest rates.

Most Australian economic data releases in June pointed to strong growth. Q1 real GDP rose 0.8% q-o-q, 3.3% y-o-y with strong underpinning from domestic demand with GNE, or Gross National Expenditure, up 2.5% q-o-q. April retail sales rose to a record high and were up 0.9% m-o-m. May employment rose 60,600 with the unemployment rate staying down at 3.9%, the lowest reading since 1974. Annual wage growth holding down at 2.4% y-o-y in Q1 2022 is about to rise after the Fair Work Commission granted a 5.2% rise to the Minimum Wage and 4.6% lift to other higher paid awards.

The only part of the Australian economy starting to show softness is the most interest-rate sensitive part, housing. The value of new home loans in April fell by 7.3% m-o-m while April home building approvals fell by 2.4% m-o-m. House prices have started to fall and are declining around 1% monthly in both Sydney and Melbourne.

The RBA is now on a mission to cap inflation by bringing demand growth in the economy back in line with growth in supply. That mission will require more rate hikes over a short time period to take borrowing interest up to at least a more normal level based on a cash rate around 2.50%. We see the RBA hiking the cash rate 50bps in July to 1.35% then perhaps pausing in August and September before delivering three 25bps rate hikes in October, November and December taking the cash rate to 2.10% by the end of 2022. The risk case is more aggressive hikes if inflation shows signs of moving higher than 7% the RBA expects in Q4 this year.