The key messages from the downside US CPI surprise in October are that their annual inflation rate has moved past the peak for this cycle and can be expected to decline further through to mid-2023. Two near-term disinflationary forces are in play in the US, softer goods prices (the prices of new and used motor vehicles and apparel fell in October) reflecting improving supply and weakening demand and a base effect or very high month-on-month CPI increases a year ago compared with more modest month-on-month increases currently and over the next few months. These two disinflationary effects may continue to lean against continuing upward pressure on the prices of most services, especially the rising cost of shelter and could see annual US CPI inflation slide to 4% y-o-y to 5% range by mid-2023.
In October, the base effect and moderation in many goods prices helped to offset still high month-on-month increases in the prices of food, gasoline and shelter causing the CPI to rise less-than-expected in October, +0.4% m-o-m (consensus forecast +0.7%), +7.7% y-o-y (consensus +8.0% y-o-y). Barring any unusually big rises in the Prices of US food and energy over the next few months, US annual CPI inflation should continue to moderate, especially in May and June 2023 when the back-to-back 1%+ month-on-month CPI increases reported for May and June 2022 fall off the annual inflation base calculation and are replaced by hopefully much smaller monthly increases in May and June 2023.
On our best estimate, US annual CPI inflation falls to 4% y-o-y by mid-2023, still double the Federal Reserve’s 2% target, and the bad news is that annual inflation may climb again for a period from June 2023 as the base calculation takes account of back-to-back near zero month-on-month CPI changes in July and August 2022.
Another key reason, beyond base effect calculations and rising service prices, why US annual CPI inflation stays sticky above 4% in the second half of 2023 extending in to 2024 is that US wages are still rising around 5% y-o-y on all measures. US annual wage growth needs to slow to around 3.5% y-o-y to provide any chance for CPI annual inflation to moderate to around 2% sustainably.
To get annual US wage growth to moderate near 3.5% y-o-y the Fed needs to engineer some rise in the US unemployment rate, probably to around 4% for several months from the current 3.7%. Until the Fed is convinced that the unemployment rate is on track for a stay of several months around the 4% mark, it cannot say credibly that wage growth will moderate to annual wage change consistent with inflation eventually returning to 2%. The Fed needs to continue hiking the Funds rate, although the signs that inflation is over the hump give it the option to hike the Funds rate by smaller amounts.
Turning to Australia, our annual CPI inflation rate still has a little way to go to peak for this cycle. The peak annual inflation rate based on the quarterly CPI is likely to occur with the Q4 2022 CPI report, out in late January 2023. At this stage, the Q4 CPI looks set to rise around 2.0% q-o-q, 8.0% y-o-y and if it does, Australian annual CPI inflation will be higher than US annual CPI inflation.
Australian annual CPI inflation above US CPI inflation is unlikely to persist far in 2023. Near-term disinflationary factors such as base effect and moderating goods prices will be in play in Australia in 2023, as they will be in the US, helping to temper the impact of spikes in energy and food prices, and upward pressure on service prices.
Where Australia has a longer-term disinflationary advantage over the US is comparatively low annual wage growth so far. The US needs to drag down inflation-supporting wage growth around 5% y-o-y whereas Australian annual wage growth, probably around 3% y-o-y when the Q3 2022 wage price index is released on Wednesday, can rise a little further and still be consistent with the RBA achieving its 2-3% inflation target over time.
However, it is a different story if Australian annual wage growth accelerates rapidly and well above 3.5% y-o-y on the wage price index measure. Although we are not expecting this to happen, if it does then the likelihood diminishes of the RBA achieving its 2-3% inflation target and the RBA will need to work harder to suppress demand and drive up the unemployment rate.
At this stage, while there are pockets of rapid wage growth in industries where labour skills are in very short supply or in areas of particular need – the very low-paid, there are also many large employment groups where pay rises are still capped at 3% and less. The Government’s current push to change the wage bargaining landscape towards industry-wide bargaining is an unknown quantity for 2023 in terms of how much it may lift wage growth.
The RBA can take comfort for the Australian inflation outlook on the basis of low wage growth to date.
However, the outlook for wage growth is at best hazy. The tightness of the labour market and changes to industrial relations mean that the RBA will need to monitor labour market, wage growth and inflation outcomes over several quarters checking that it is still on the path of lowering inflation towards target over time.
During this period, the RBA may need to lean a little harder to suppress demand. Our current view is that the RBA will need to hike another 25bps in December taking the cash rate to 3.10% with a final 25bps tilt early in 2023 to 3.35%.
The data releases indicating wage and inflation pressure will matter. If the Q3 wage price index this week shows annual wage growth above 3% y-o-y that all but guarantees outcomes during 2023 with annual wage growth above 3.5% y-o-y implying the need for the cash rate to peak higher than our current forecast. Signs that the unemployment rate is sticking down around 3.5%, would have a similar impact on the cash rate outlook, as would annual inflation pushing much above 8% in Q4.