In July inflation cooled while major economies such as the US seemed less likely to experience recession and labour markets remained tight. Central banks remained cautious about recent reductions in annual inflation with some continuing to hike official interest rates. The US Federal Reserve (Fed) and the European Central Bank (ECB) both hiked rates 25bps at their July policy meetings and both warn that fight to reduce inflation to their respective targets may have further to run. Financial markets are discounting the warnings and consider that the current interest rate hiking cycle is complete. That optimism is understandable given falling annual inflation rates, but probably misplaced given the potential for tight labour market conditions to keep inflation above central bank targets for a protracted period.
In the US, most economic reports released in July show firm economic activity. The advance reading of Q2 GDP rose at 2.4% annualised pace, compared with 2.0% in Q1. Q2 consumer spending at 1.6% annualised, although softer than in Q1, is still firm. June retail sales are up 0.2% m-o-m after gaining 0.5% in May and July consumer confidence is up sharply at 117.0 from 110.1 in June. Household spending in the US appears to be gaining a second wind even in the face of higher interest rates. The strong US labour market (non-farm payrolls rose 209,000 in June after lifting 306,000 in May with the unemployment rate down one notch to 3.6%) is contributing to real income growth. Average hourly earnings rose in June by 0.4% m-o-m, 4.4% y-o-y against the CPI up 0.2% m-o-m, 3.0% y-o-y.
The reduction in inflation in the US to 3.0% y-o-y (although with underlying inflation measures still above 4% y-o-y) is largely the result of lower energy prices and goods prices settling back after the international supply chain disruption of recent years. Stickier service price inflation means that the Fed cannot rely on a quick return to its target of 2% inflation. That still quite prolonged battle to achieve its target explain the latest 25bps rate hike by the Fed to 5.50% and indicate the possibility of one or two more rate hikes before the Fed completes its task.
In China, economic recovery remains lack luster. Q2 GDP rose less than expected by 0.8% q-o-q (+2.2% q-o-q in Q1) and while the weak, lock-down impacted GDP base in Q2 2022 saw annual GDP growth rise to 7.3%y-o-y in Q2 2023 from 4.5% y-o-y in Q1, annual growth is set to falter in the second half of 2023. June readings were mostly soft. Exports fell 12.4% y-o-y (May -7.5%) and imports were down 6.8% y-o-y (May-4.5%). June fixed asset investment spending and retail sales both moderated to respectively 3.8% y-o-y (May 4.0%) and 3.1% y-o-y (May 12.7% y-o-y). The only major indicator showing acceleration in June is industrial production, up 4.4% y-o-y from 3.5% in May. The slow Chinese economic recovery from the phase of policy restrictions and lockdowns last year has left an economy with excess capacity causing downward pressure on prices. China’s CPI fell 0.2% m-o-m in June generating zero annual inflation. June producer prices fell 5.4% y-o-y.
Europe remains on the border of recession in July with weak spending on goods offset by still strong spending on services. Europe’s labour market remains tight with the unemployment rate in May sticking at a quarter-century low of 6.5%. Inflation is falling, down to 5.5% y-o-y in June, but elevated wage settlements make it unlikely that inflation will fall to the ECB’s target over the next year or two. At the ECB’s July policy meeting the ECB hiked the deposit rate 25bps to 3.75% and indicated that further hikes will be needed to contain inflation. Britain continues to face higher inflation than most, although it has receded just below 8% y-o-y. Wage claims are particularly high in Britain and the Bank of England meeting later this week is likely to hike the base rate 25bps to 5.25%.
In Australia, spending on housing is holding up for the time being in the face of higher interest rates, but retail spending is weakening. June retail sales fell by 0.8% after lifting 0.8% in May and it seems likely that Q2 real retail sales due out this week will be down around the -0.6% q-o-q recorded in Q1. Household consumption contribution to Q2 GDP will be soft and possibly negative. The weakness in household spending, however, has not been reflected in labour market conditions, which remain strong.
Employment growth was stronger-than-expected again in June with employment up 32,600 after rising by an even greater 76,600 in May. The unemployment rate has held down at 3.5% in both May and June, close to a 50-year low and low enough to add to existing upward wage pressure in the economy and making the RBA’s task of reducing inflation to 2-3% target harder. The Q2 wage price index out in mid-August may show annual wage growth above 4% y-o-y.
Inflation is past its peak and has moderated more than expected in the first half of 2023. The Q2 CPI rose 0.8% q-o-q taking annual inflation down to 6.0% y-o-y from 7.0% in Q1. The monthly CPI for June is lower at 5.5% y-o-y and measures of underlying inflation are sitting between 5.0% y-o-y and 5.9%. Lower goods prices are helping to moderate still high and sticky service price inflation above 6% y-o-y. While the moderation in inflation is encouraging, it remains high compared with the RBA’s 2-3% inflation target and progress towards the target remains a lengthy affair that risks elevating community inflation expectations.
The RBA has enough evidence of moderating growth in household spending and moderating inflation to reduce the urgency to deliver more rate hikes, but the need for more rate hikes remains while labour market conditions remain very tight. Each RBA meeting over the next few months is likely to be a lineball decision between holding the cash rate or tweaking it higher. We see another one or two rate hikes over the remainder of this year taking the cash rate to a peak of 4.35%, possibly 4.60%, before moderating labour market conditions set in providing the RBA with comfort to call time on the current rate hiking cycle.