Global economic growth is losing pace but inflation remains uncomfortably high according to economic reports and data releases through August. Also concerns are emerging that inflation could stay higher for longer adding to the difficult task faced by central banks trying to tame it. The approaching northern hemisphere autumn and winter will add demand for energy while, especially in Europe, supply is constrained forcing up prices. Governments are under pressure to provide cost-of-living support payments and back calls for higher wages which by underpinning aggregate demand undermine the inflation-fighting efforts of central banks that work by suppressing demand. Interest rates may need to be higher for longer in response.
In the US, many leading indicators of economic indicators of economic activity are weakening. The most interest rate sensitive part of the economy, housing, is softening. July pending, new and existing home sales were down respectively 1.0% m-o-m; 12.6%; and 5.9% extending falls in June. July home building permits and starts fell respectively 1.3% m-o-m and 9.6%. The August National Association of homebuilders index fell into contraction territory at 49 from 55 in July.
While US housing activity is in the doldrums, general US business activity is still holding up and consumer spending remains relatively firm. The July ISM manufacturing PMI edged down to 52.8 from 53.0 but remains in expansionary territory while the July non-manufacturing (services) PMI improved to a still strongly expansionary reading of 56.7 from 55.3. Personal spending in the US consolidated a strong 1.0% m-o-m gain in June with a lift of 0.1% in July. Notwithstanding rising interest rates, US households are still fit to spend experiencing strong wage growth, average hourly earnings up 0.5% m-o-m, 5.2% y-o-y in July, rising employment with non-farm payrolls up 528,000 in July and the unemployment rate in July at 3.5% the lowest since 1969.
The US economy is still exhibiting growth momentum notwithstanding a quirky Q2 GDP growth reading at -0.6% annualized that masked 1.5% growth in consumer spending. The residual strength in US aggregate demand means that signs that the US annual inflation rate may have peaked in July at 8.7% y-o-y, down from 9.1% in June are tentative at best. Moreover, even as the annual inflation rate reduces on base effect, the cycle lowpoint for annual inflation next year is likely to be well above the Federal Reserve’s 2% target. Chairman Jerome Powell warned last week that the Fed has much work to do to contain inflation and will not be in a position to consider cutting the Fed funds rate until 2024 at earliest.
In sharp contrast to the excessive demand underpinning inflation in the US, China’s economy continues to suffer policy-induced weakness. Residential property development companies remain financially distressed. Zero-tolerance of covid outbreaks continue to cause disruptive shutdowns. Severe drought in several regions of southern China is cutting farm production. The authorities are trying to compensate by easing monetary policy and directing local government to spend more on local infrastructure projects but most indicators point to weak economic growth. July fixed investment spending moderated to 5.7% y-o-y from 6.1% in June; industrial production edged back to 3.8% y-o-y in July from 3.9% in June; and hoped for strengthening of retail sales in July was dashed by slippage to 2.7% y-o-y from 3.1% in June. China’s inflation rate remains low at 2.9% y-o-y providing leeway for the Peoples’ Bank of China to continue easing monetary policy, but that provides cold comfort when covid-containment restrictions and quarantine rules are imposed arbitrarily. China’s soft growth path looks set to continue.
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 related to the Ukraine War. Europe’s inflation rate is high and rising. CPI inflation rose to 8.9% y-o-y in June, while in the UK inflation is at 10.1%. Producer price inflation remains exceptionally high above 35% y-o-y and looks set to rise much higher in the northern hemisphere winter because of soaring energy prices. The European Central Bank is warning that while Europe could slide in to recession the policy priority is to contain inflation. It has started to tighten monetary policy including a 50bps lift to its deposit rate in late July to 0.0%. A series of rate hikes is likely over coming months. In the UK, The Bank of England, hiked 50bps in early August taking the base rate to 1.75%. Several more rate hikes are likely given the UK faces annual CPI inflation approaching 20% y-o-y over the the next few months amid mounting labour disputes seeking pay increases above 10% in some cases.
In Australia, aggregate demand is holding strong for longer notwithstanding clear signs of slowing in housing activity. The approaching Q2 GDP report is likely to show q-o-q growth above 1.0% with annual growth accelerationg towards 4% supported by strong growth contributions from household consumption spending (real retail sales rose 1.4% q-o-q in Q2) and net exports on a ballooning trade surplus through Q2. The labour market remains very strong with the unemployment rate down to 3.4% in July, the lowest reading since August 1974. Also, while the Q2 wage price index showed wage growth at a still modest 2.6% y-o-y a more contemporary indicator of wage growth, the new monthly SEEK advertised salary guide shows wage offers up 4.1% y-o-y.
There is a disconnect between weakening consumer sentiment indicators over recent months and retail spending up 10% y-o-y in May and June making new record highs in both months. Catch-up spending after the pandemic lockdowns still seems to be in play and is changing its spots with greater emphasis more recently on spending on services. The strength of aggregate demand is stretching limited supply of goods and services and serving to underpin inflation in the near term. The RBA has lifted its inflation forecasts substantially this year and now expects inflation to peak around 7.75% in Q4 before subsiding through 2023 to 4% and then 3% in late 2024.
The RBA’s latest inflation forecasts imply that it has to return the cash rate at the very least to near its medium-term 3% inflation forecast. If conditions change forcing the RBA to lift its inflation forecasts further, the cash rate may need to be pushed above 3% and that is where the risk increasingly seems to lie. Factors coming in to play that may push inflation higher than the RBA is forecasting currently and for longer include the extent of approaching increases in gas and electricity prices; more wet conditions on the eastern seaboard this spring and summer restricting food supplies and elevating prices; as well as the risk that the Jobs and Skills Summit later this week becomes the catalyst for ditching wage-growth restraining enterprise bargaining in favour of wage-growth accelerating industry-wide bargaining.
For the time being our view remains that the RBA will hike the cash rate currently at 1.85% to 2.60% by the end of this year. We recognize that the risk is that higher cash rate than we are currently forecasting may be needed. Also, it is becoming clearer that higher interest rates may need to stay in place longer.