The global economy continues to grow above trend despite mixed growth performance in the major economies. US GDP growth in Q2 accelerated above 4% annualised pace and was the strongest in four years. In China growth moderated slightly in Q2 to 6.7% y-o-y and European economic growth in Q2 (data due this week) is expected to pull-back closer to 2.0% y-o-y but remains above long-term trend. Australian annual GDP growth accelerated to 3.1% y-o-y in Q1 and looks set to maintain or improve on that growth pace in Q2. Although there are reasons why global growth pace could moderate in Q3 – in the case of the US from fading positive influence from tax cuts; rising interest rates and international trade friction – growth pace looks set to remain above trend and fast enough to continue stretching economic capacity increasing the risk of a burst higher in inflation. Central banks may soon step up the pace at which they withdraw monetary stimulus.

US annualised GDP growth jumped up from an upwardly revised 2.2% in Q1 2018 to 4.1% in the advance reading for Q2. Strong US growth in Q2 was impressively broad-based with consumer spending up 4.0% annualised, business investment spending up 7.3% and net exports contributing 1.1 percentage points to growth. The US economy was literally firing on all cylinders in Q2 assisted by exceptionally strong growth in business earnings plus a big lift in household income too driven by strong wages growth as well as another strong increases in employment during the quarter. Business and consumer sentiment readings remain elevated and mostly point to continuing strong economic growth in Q3. Despite past strength and signs of momentum in business and consumer spending most analysts expect a turn for the worse in the US economy on legitimate concerns about less influence from lower taxes, the escalating trade war and the impact of higher interest rates. When income growth is so strong in the US economy, however, the US economy may be able to overcome negative influences more easily than is widely expected.

Whether the US economy continues to grow as strongly as it did in Q2, or at a lower pace is probably immaterial in terms of the looming threat of higher inflation. The signs have been building for several months that inflation has started to rise and will rise further in the US over coming months. The CPI lifted to 2.9% y-o-y in June with a core reading of 2.3% y-o-y. Producer price inflation accelerated in June to 3.4% y-o-y from 3.1% in May, a sign of building pipeline pressure on retail prices. Annual growth in average hourly earnings was 2.7% y-o-y in both May and June, but a lengthening list of labour shortages in key sectors of the US economy would seem to herald average hourly earnings pushing up to 3.5% y-o-y or higher over the next few months.

The Federal Reserve is aware that inflation is likely to push higher and has heralded another two 25bps rate hikes in the remaining months of 2018 taking the funds rate to 2.50% by the end of the year. If the economic data over the next few months shows “surprising” strength, an increasing likelihood in our view, the Fed may lift the funds rate more aggressively than it is planning currently. It is fair to say that the US bond market is ill prepared for continuing US economic strength and a more aggressive Fed presenting risk of periodic sharp sell-offs in the US bonds and pushing yields materially higher by the end of 2018.

In China, GDP growth edged down to 6.7% y-o-y in Q2 from 6.8% in Q1 and leading indicators are pointing to further mild deceleration in Q3. China’s response to the first move by the US increasing a range of tariffs on Chinese imports has been a mix of retaliatory tariff increases on US goods, allowing a downward drift in the renminbi exchange rate plus moves to stimulate domestic demand including easier monetary policy. The Peoples’ Bank of China surprised with a 50bps cut in the Reserve Ratio for banks that took effect early in July and cut across earlier policy measures aimed largely at reducing credit. Encouragingly, the authorities in China can claim some success rebalancing economic growth drivers more in favour of domestic spending, especially retail spending. Retail sales accelerated to 9.0% y-o-y in June from 8.5% in May. A less encouraging development for the rest of the world is that China’s producer prices were accelerating (up to 4.7% y-o-y in June from 4.1% in May) before the start of recent trade tensions with the US and the way that China is responding in the trade war, especially through currency depreciation, may boost China’s producer prices and ultimately international inflation a lot more.

In Europe, Q2 GDP due this week is likely to show that annual growth has moderated further to 2.2% y-o-y from 2.5% in Q1. Growth is still above long-term trend and sufficient to keep Europe’s unemployment rate falling and in countries like Germany down to a very low level that is starting to prime higher wages growth and some inflationary pressure. So far the response by the European Central Bank is to assume that inflation is still modest, but high enough to call in to question the need for extraordinary monetary accommodation. At its June policy meeting the ECB announced that quantitative easing bond purchases would step down from 30 billion euro a month to 15 billion euro at the end of September and would finish at the end of December 2018. At its July policy meeting the ECB reaffirmed its June decision and in the question and answer session after President Draghi’s statement affirmed that market expectations of a first ECB rate hike in October 2019 were reasonable.

In Australia evidence is building that that the pronounced rise in Q1 GDP (1.0% q-o-q, 3.1% y-o-y) could be reinforced in Q2. Monthly retail trade showed strong growth in April, 0.4% m-o-m, and in May, 0.5%. Consumer sentiment has improved to a 4-year high in July according to the Westpac survey and business sentiment remains strong according to the NAB monthly survey. Employment growth took a much stronger turn in June, up 50,900 and mostly full-time positions, up 41,200. The unemployment rate fell to a five-year low point just under 5.4%. Housing activity remains a soft spot for the economy, and there are concerns that household sector could be constrained by weak wages growth and high household debt.

Inflation is still just about contained with annual headline inflation accelerating to a three-year high 2.1% y-o-y in Q2 with underlying annual inflation steady at 1.9% y-o-y. We see risk of higher inflation not far ahead. Rising international producer prices combined with a softer Australian dollar will continue to push up the price of imported goods. Locally, the labour market has tightened to the point where a building acceleration in annual wages growth is likely. Food prices, which deflated in Q2, are likely to inflate substantially because of the impact of severe drought in Queensland and New South Wales. Our view is that RBA will come under pressure to hike the cash rate later this year and that the market is underestimating considerably the upward pressure on the cash rate that is likely to develop over the next year. We see a first 25bps rate hike probably at the November RBA policy meeting.