In August, progress towards lower inflation was patchier in most major economies other than in China and Australia. In China, the faltering economic recovery and excess capacity are promoting deflation. In Australia, annual inflation, although still high, fell sharply mid-year. Softer Australian retail spending and labour market conditions improve the possibility of a return to inflation within the RBA’s target range by late 2025. In contrast, demand is looking firmer than in Australia in the US and Europe pointing to stickier inflation and more work to do for their central banks lifting interest rates. Australian interest rates are well below their US counterparts and likely to stay well below adding to factors pushing down the Australian dollar exchange rate.
In the US, most economic reports released in August 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. July retail sales are up 0.7% m-o-m (core retail sales up 1.0%) after gaining 0.2% in June. July housing indicators released so far are firmer with permits up 0.1% m-o-m and start up 3.9%. July industrial production rose 1.0% m-o-m. The US labour market remains tight as well with non-farm payrolls up 187,000 in July, average hourly earnings up 0.4% m-o-m, 4.4% y-o-y and the unemployment rate down to 3.5% from 3.6% in June.
Progress on the US inflation front was patchier in July with annual CPI inflation rising to 3.2% y-o-y from 3.0% in June with the core CPI, excluding food and energy prices edging down to 4.7% y-o-y from 4.8% in June. After hiking the Funds rate another 25bps to 5.50% in July the Fed has indicated that it has not closed the door on further rate hikes and in any event interest rates will need to stay high for a prolonged period to deal with sticky inflation. The US bond market showed signs of taking to heart the Fed’s message of higher rates for longer pushing up longer-term bond yields further above 4.00% in August.
In China, economic recovery remains lack luster prompting some policy initiatives to try and bolster growth. July data reports were all softer than expected. Exports fell 14.5% y-o-y (June -12.4%) and imports were down 12.4% y-o-y (June -6.8%). July fixed asset investment spending rose 3.4% y-o-y, down from 3.8% in July; July industrial production rose 3.7% (June +4.4%); and retail sales rose 2.5% y-o-y (June +3.1%). Despite a 0.2% m-o-m rise in China’s CPI in July, the annual CPI change slipped into deflation, -0.3% y-o-y from up 0.2% in June. The Peoples’ Bank of China reacted to the disappointingly weak data adjusting lower two of its official interest between 10-15bps but that will not change the main problems besetting China’s economy too low return on saving, too much household saving and loo little retail spending.
In August, Europe’s leading economic indicators are pointing to recession ahead with the manufacturing PMI down at 43.7 and the services PMI at 48.3, both below the 50 expansion/ contraction marker. The latest June retail sales, -0.3% m-o-m, and industrial production, -0.6% m-o-m, were weak but residual strength in the labour market with the unemployment rate down to a quarter-century low 6.4% and high wage settlements are making getting inflation down a slow affair. Annual CPI inflation in Europe moderated a little, to 5.3% y-o-y, in July but the core CPI is sticky around 5.5%. Both remain well above the ECB’s inflation target. The story is similar in the UK where inflation and wage settlements are higher than in Europe. Both the European Central Bank and the Bank of England hiked rates at their latest policy meetings by 25bps to respectively 3.75% (ECB’s deposit rate) and a 15-year high 5.25% (BoE’s Base rate). Both central are caught between clear signs that their economies are slowing, but also evidence that inflation is subsiding too little and too slowly. Both central banks are likely to hike rates further over the next few months.
In Australia, there are clearer signs that household spending is weakening. June retail sales fell by 0.8% m-o-m and Q2 real retail sales were down 0.5% q-o-q, the third consecutive quarterly fall and producing a fall in annual growth of retail sales (-1.4% y-o-y) for the first time, barring the Covid period fall, since the 1991 recession. The strength in spending on housing is also showing signs of fading with less pronounced monthly increases in house prices and the value of new home loans down 2.8% m-o-m in June.
The July labour force report also hints at the possible beginning of softening in labour market conditions. Employment fell by 14,600, albeit after strong monthly increases in May and June. The unemployment rate rose in July to 3.7% from 3.5% in June. Wage growth also came in softer than expected in Q2 with the wage price index up 0.8% q-o-q (the third consecutive quarterly rise of 0.8%) and up 3.6% y-o-y, down from 3.7% in Q1. There are several bigger wage increases – the minimum wage rise, age-care settlement and higher public sector settlements – that will push the wage price index higher in Q3 and Q4, but at this stage, annual change in the wage price index may peak just above 4% y-o-y.
In August, the RBA left the cash rate unchanged at 4.10% for a second consecutive month. Essentially the RBA is balancing evidence of slowing demand caused by earlier rate hikes against the residual risk that inflation may not fall far enough (within 2-3% target) quickly enough. On the latest RBA forecasts produced in the August Monetary Policy Statement the RBA sees inflation falling inside target band by late 2025. It is monitoring data to gauge whether the forecast is on track and in August most data reports were pointing towards achieving the inflation forecast.
Looking ahead, each month in the near-term will present a fine balance between too much strength in demand and the labour market or sufficient softening to achieve low and sustainable inflation in 2025. In short, the RBA’s policy options for the coming months will be to leave the cash rate unchanged at 4.10% or tweak it higher.
It seems more likely that the cash rate may have peaked at 4.10%, but if it has that will highlight a growing issue of Australia’s interest rates tracking further below US interest rates. The widening interest rate differential could add to downward pressure on the Australian dollar exchange rate from weaker export commodity prices in the soft global economic growth environment. A weak Australian dollar adding to import prices could add to the difficulty returning inflation to target. That may not present cause for the RBA to hike the cash rate further, but it could limit the ability of the RBA to cut rates in the future. At the very least the cash rate looks set for a prolonged stay at 4.10%.