Inflation has taken over from longstanding – 30 years – disinflation during 2021 and it will not go away during 2022 and 2023. The annual rate of inflation in most major economies including the US, Europe and Australia may dip later this year on base effects, latest monthly inflation readings running lower than monthly readings a year earlier in the peak of the supply chain crisis, but the dip is likely to be temporary and modest. Even at the “base effect” low points annual inflation will be high relative to central banks’ inflation targets.
Annual inflation in the OECD is pushing up through 5% y-o-y using the latest November and December 2021 readings from member countries. Base effects may see a brief dip to 4% in the second half of 2022 but that is still well above the average central bank inflation targets of OECD member countries around 2.5%. Crucially, the US is on the high side of the OECD average at 7.0% y-o-y CPI inflation in December 2021 and unlikely to see a dip below 5% in 2022 against the Federal Reserve’s 2% inflation target.
The US Federal Reserve (Fed) is belatedly thinking about reacting to the new world of higher inflation. It is starting to recognise that high inflation will not go away other than temporarily on base effects and even then, the low point will be too high. Too many factors are working towards underpinning inflation. The Fed has moved beyond viewing high inflation as being temporary.
Supply chain constrained supply struggles to match strong final demand in the US which is still supported by policy stimulus, high household wealth, accelerating wage growth and high household savings ready to be spent on any positive change in consumer sentiment. Supply chain problems while past their worst are rekindled with every new wave of covid including the latest omicron outbreak adding to the problems of scarce labour supply.
US inflation was mostly an issue of high demand for goods stretching constrained supply of goods (demand-pull) through 2021 but in 2022 it is broadening to the supply and demand of services as well. US CPI heavyweight, the cost of shelter, is rising and is set to stay stickily high running beyond 2022 through 2023. The broadening demand-pull pressure on the US CPI in 2022 is being reinforced by cost-push from rising wages pushing up through 5% y-o-y.
The Fed is coming late to the inflation fight. Its actions so far amount to tapering monetary stimulus from its bond-buying program but no change to the 0-0.25% Funds rate. The talk among Fed presidents and governors is that the Fed will need to deliver three or four rate hikes in 2022 taking the funds rate to 1.25% at most by year-end. It seems odd to be talking about the Fed’s current rate hiking plan as being overly cautious, but high US inflation and the forces underpinning it will not start to be tamed until US interest rates are high enough to slow US growth below long-term trend. The Fed funds rate will need at least a two on the front and possibly a three.
The longer the Fed draws out the process of getting the Fed funds rate up, the greater the risk that demand stays very strong, keeping inflation elevated and increasing the need for more rate hikes over time. On the Fed’s current rate hiking plan, the Fed will lift the funds rate 25bps every second FOMC meeting during 2022 starting in March. That plan runs the risk of needing to repeat again or accelerate in 2023 and 2024.
We are watching the 26th January FOMC meeting to see if the Fed adjusts its rate hiking plan again. It could and should hike the funds rate at that meeting and indicate a more rapid lift in the funds rate beyond hiking at each six-weekly FOMC meeting to get the funds rate up to a demand-crimping, inflation-fighting level relatively rapidly. That is what should happen in our view, but the odds still seem stacked in favour of the slower inflation accommodating pattern of rate hikes.
While inflation is very high in the US, in Australia inflation is climbing comparatively slowly so far. Our Q4 CPI will be released on 25th January and we expect a quarterly rise around 1.0% taking the annual CPI inflation rate up to 3.2% y-o-y from 3.0% in Q3. Underlying inflation in Australia was 2.1% y-o-y in Q3 and we think will lift to 2.3% in the Q4 report. Underlying annual inflation is working its way up through the RBA’s 2-3% target band and headline CPI inflation is at or just above range.
Australian inflation has been demand-pull so far with occasional bursts of very strong demand between covid-restriction induced setbacks (whether of the official lock-down type or self-imposed omicron type) stretching supply.
One important area of demand for housing, purchase and rent, has been consistently strong regardless of the covid waves and restrictions. The housing component of Australia’s CPI is likely to push higher through 2022. Other components of the CPI where demand will stretch supply will push prices higher too, notably education, health services and a wide range of imported factory goods affected by past big increases in factory gate prices overseas, a softer Australian dollar exchange rate, and local scarcity of supply.
Demand-pull factors alone look sufficient to keep Australian inflation higher albeit with small and brief base-effect pullback mid-to-late 2022. Australia has lacked significant wage-push inflation pressure so far. High, but not unduly disturbing inflation so far; the prospect of some base-effect pullback in annual inflation later in 2022; and low and slow growth in wages allow the RBA to take more time before tackling inflation.
We see that time running out quite rapidly. Parts of the labour market were coming under pressure to lift wages faster late in 2022. The omicron outbreak is a two-edged sword in terms of wage pressure. The short-term and probably quite brief setback to spending may limit employers’ willingness and ability to pay higher wages. However, higher absenteeism during the omicron outbreak, is reducing supply of labour relative to demand and is lifting wages whether through supplements to entice temporary workers to fill gaps or giving more paid hours of work to those still fit enough to work.
More importantly, beyond the omicron wave Australia’s falling unemployment rate, down to 4.6% in November and possibly much lower in the December number out this Thursday spells waves of higher pay claims through 2022 and 2023. The RBA will not be able to rely on slow, low past wage growth continuing in the broadening inflationary environment that it has also had a hand in promoting by leaving interest rates ultra-low for too long.
The RBA now faces a period where every quarterly CPI and wage report will be a challenge to its view that it can be “patient” with monetary policy. There is very little room for upside surprises and the risk is squarely on the side of upside surprises. The Q4 2021 CPI next week; the Q4 2021 wage price index in mid-February; the Q1 2022 CPI in late April; and the Q1 2022 wage price index in mid-May could and probably will test the RBA’s patience.
Our view is that accumulating evidence of higher and stickier inflation will push the RBA to deliver a rate hike in June or July. By then, the US Fed facing much higher and stickier inflation than in Australia may be considering its third or fourth rate hike.