Annual inflation is past its peak in the US and is moderating quite sharply. Financial markets are looking with some justification from recent US inflation and wage data towards the end of the Federal Reserve’s current rate hiking cycle with smaller 25bps rate hikes at the next two or three policy meetings to complete the rate hiking program. Markets are starting to assume that other central banks will follow a similar modest pattern remaining rate hikes given that inflation appears to have passed its peak in most other places too.
This view that the inflation battle is almost over is gaining traction, but still faces challenges over coming months. The biggest challenge is that progress getting inflation down towards official central banks’ targets (2% for the US Fed and ECB and 2-3% for the RBA) may turn in to a stickier more protracted battle everywhere largely because of tight labour market conditions that mean that annual wage growth cannot be expected to be much below 3.5% y-o-y over the next few years.
The US Fed, for example, while providing guidance that moderating annual inflation (latest evidence the reduction in annual CPI inflation in December to 6.5% y-o-y from 7.1% in November) and moderating annual wage growth (December average hourly earnings down to 4.6% y-o-y from 4.8% in November) provide reason to hike the Funds rate more slowly is also saying that persistently tight labour market conditions may provide cause for the peak in the Funds rate once reached to stay in place longer than in previous cycles.
Whether the Fed’s stickier interest rate peak warning – a warning financial markets are ignoring for the time being on the flurry of lower December US inflation and wage data – comes to fruition will depend upon whether US labour market conditions stay tight.
Evidence is unrelenting of extremely tight US labour market conditions. Non-farm payrolls continue to squeeze higher, averaging above 200,000 a month in the closing months of 2022. The US unemployment rate is down to 3.5% in December, the lowest reading in more than fifty years. Weekly initial jobless claims have fallen toward 200,000 over recent weeks, another sign of a very fully-employed economy and one that is unlikely to see wage growth decelerate much more.
Of course, labour market indicators lag developments in the general US economy and there are signs among leading indicators that the US economy will slow and probably experience recession this year. The problem is that indications of current US economic activity remain relatively firm. If the much-heralded US recession eventuates it is unlikely to start before Q3 and may not show in labour market indicators consistently starting to soften until the end of this year or early in 2024. That provides little opportunity for the Fed to start cutting interest rates this side of 2024.
Turning to Australia, reasons to expect the RBA to complete its rate hiking cycle early this year are being challenged by strong economic readings and evidence that inflation has not peaked. The November monthly CPI reading showed a rise in annual inflation to 7.3% y-o-y from 6.9% in October. Three of the most heavily weighted components of the CPI rose at 9% y-o-y and more, transport, +9.0% y-o-y; food and non-alcoholic beverages, +9.4% y-o-y; and housing, +9.6% y-o-y. Transport and food may moderate, but housing looks set high with fast rising costs of building materials and rent starting to rise fast.
The Q4 CPI due later this month is likely to show a rise in annual inflation from 7.3% y-o-y reported in Q3. Australian inflation relative to US inflation has migrated through the closing months of 2022 from sitting below US inflation to rising above and with a widening positive gap above US inflation as US annual inflation moderates while Australian annual inflation continues to rise a little while longer.
Australian economic indicators, other than those relating to housing, remain strong. November retail sales rose by 1.4% month with evidence the post-restriction freedom spending spree is still in full cry with no sign yet of dampening influence from higher interest rates. Australia’s strong international trade position, even as the threat of global recession looms, is getting brighter in a world desperately short of food and energy commodities and with our biggest customer China on a charm offensive and starting to relax trade barriers limiting imports from Australia.
While Australian wages have not risen as fast as in the US, very tight Australian labour market conditions persist. Employment rose by 64,000 in November and the December reading due this week is expected to see another 20,000+ increase. The labour force participation rate, at a record high 66.8% in November may have held that extraordinary rate in December which implies the unemployment rate holding down at 3.4%, a near fifty-year low. These relentlessly tight labour market conditions continue to place upward pressure on Australian wage growth. While Australian wage growth at 3.1% y-o-y in Q3 sits well below US wage growth at 4.6% y-o-y, Australian annual wage growth is accelerating while US wage growth has started to decelerate.
These comparisons between the US where inflation and wage pressure are on the way down whereas in Australia, they are rising highlighting an anomaly where official Australian interest have been rising at slower pace than US official rates and sit respectively at 3.10% for Australia and 4.50% for the US.
Australia, with much higher household debt than the US and much less of that debt at fixed rate is a much more variable-interest rate sensitive than the US. That may account for why the Australian official rate more than a percentage point lower than the US equivalent is appropriate. Until recently, the bigger inflation challenge in the US also indicated a need for a higher US official rate than in Australia. But that higher inflation challenge in the US argument is rapidly diminishing.
A case is starting to develop that Australia’s resilient economy is adding to the challenge containing inflation. The RBA may need to lift Australia’s cash rate closer to the Funds rate peak in prospect for the US – around 5%. Australia could still be spared the need for further significant increases in the official cash rate, but it will need an unlikely shift weaker in approaching labour market and inflation reports. At this stage, they look strong. The December labour force reading this week is likely to see the unemployment rate hold down at 3.4%, or push lower. The Q4 CPI later this month, may see annual inflation push above 7.5% y-o-y and the Q4 wage price index in mid-February is likely to see a rise to 3.5% y-o-y or higher. If this is how these labour market, wage and inflation readings pan out, the now near-certain 25bps RBA cash rate hike to 3.35% in early February will not be the last and will be followed by several more rate hikes through the first half of 2023.