High inflation and ever more hawkish central banks put markets under pressure this week. Friday's upside surprise on US inflation portends a Fed staying aggressive on rates, likely taking its peers in the same direction. Even the ECB will not be able to sit this hiking cycle out, signaling a rate increase in July and a departure from an era of ultra-accommodative policy. At home, the RBA stepped up its hawkishness surprising the market with a 50bps hike.
RBA steps up normalisation with 50bps rate hike
The RBA stepped up the pace in withdrawing "extraordinary monetary support" delivering a 50bps rate hike at this week's meeting to take its policy rate to 0.85% (reviewed here). The hiking cycle started in May with a smaller hike of 25bps, though significant increases to the RBA's inflation forecasts (with the peak since revised higher) due not only to global supply factors but also domestic capacity constraints had put the writing on the wall for this week's decision.
Governor Philip Lowe's decision statement highlighted the strength of the economy and robust outlook as no longer justifing the settings required during the pandemic. With this being the case, I expect another 50bps hike in July. A speech by Governor Lowe on 21 June (Economic Outlook and Monetary Policy) looks crucial in terms of signaling the pace and extent of hikes seen over the back half of the year, on which there was little provided this week. The market is priced for another 8 hikes in 2022, though I struggle to see the RBA being able to deliver on this and anticipate the cash rate at around 2% by the end of the year.
US inflation surprised to the upside in May
May's inflation report produced the wrong kind of surprise as price pressures reaccelerated in the month. After easing back to a 0.3% rise in April, headline CPI lifted by 1% month-on-month in May to comfortably clear the expected increase of 0.7%. This drove annual headline inflation to a new peak for the cycle at 8.6% (vs 8.3% exp), resetting from the previous high of 8.5% in March. Inflation on the core rate (ex-food and energy) printed at 0.6% in May (vs 0.5% exp) and although the annual pace eased from 6.2% to 6%, this disappointed expectations for a slowing back to 5.9%.
After declining in April, fuel prices picked back up to rise by 4.1%m/m on the ongoing effects of the Ukraine war and drove the acceleration in May's inflation. The other major contributors were food (1.2%m/m) and shelter costs (0.6%m/m). Price rises in these essential items are amplifying cost of living pressures and with real incomes continuing to be squeezed, consumer sentiment is weakening.
Core services inflation remains on the rise (0.6%m/m) to be 5.2% higher over the year. Rising shelter costs (5.4%Y/Y) have been a big factor in this, as have Covid-exposed components such as airfares (37.8%Y/Y). The surge in US inflation was to a large extent driven initially by durable goods on surging demand at a time of supply chain constraints. However, durable goods are now pulling down on inflation due to a combination of base effects and consumer demand rotating back to services. Annual inflation for durable goods is now 11.4%, down from its peak pace of 18.7% in February, and replenished retailer inventories are likely to keep this trend going.
All in all, May's report raises the possibility that the Fed may need to keep hiking by 50bps beyond the June and July meetings, increasing risks to the growth outlook. The immediate focus is on next week's meeting where the updated set of economic projections will be a chance for the FOMC to reset expectations around where the peak for rates may be.
ECB succumbs to global rate hiking cycle
The set of announcements at this week's ECB meeting confirmed QE purchases will be wound down on 1 July and that the Governing Council intends to start hiking rates with a 25bps increase later that month. Described in the post-meeting press conference by ECB President Christine Lagarde as being "on a journey" of shifting away from ultra-accommodative policy, the Governing Council has plans to press on with more tightening as the summer progresses.
The decision statement noted that at the September meeting, a larger hike (presumably 50bps) was on the table if "...the medium-term inflation outlook persists or deteriorates". The guidance in the lead-up to this week's meeting was for a 25bps increase in September, though this new line implies that the inflation outlook now needs to fall in order to prevent a 50bps hike.
The updated forecasts published this week contained significant upward revisions to the inflation outlook in 2022 and 2023 such that even with a subsequent easing of price pressures, both the headline (2.1%) core rates (2.3%) are still expected to be above the 2% target in 2024. To emphasise the challenge confronting the ECB with an inflation rate currently above 8%, the Governing Council went on to signal that beyond the September meeting it anticipates a "gradual but sustained path of further increases in interest rates" will be needed.
Despite downgrading its outlook for growth across 2022 (3.7% to 2.8%) and 2023 (2.8% to 2.1%), the ECB remains more sanguine than markets on growth prospects. For that reason, markets are left questioning the viability of an ECB hiking cycle when it sees the risk of a much more severe slowdown building the longer the Ukraine war and its associated terms of trade shock persists.
Markets were also left to ponder the impact on the bond market from an impending hiking cycle. Although it had been speculated prior to the meeting that the ECB was considering a new purchase facility to help contain sovereign spreads from widening too severely, no such plans were forthcoming. President Lagarde did not discard the possibility of a new facility being developed, though for the time being the ECB would be relying on the flexibility built into reinvestments in its PEPP program.
Global risks piling up
Both the World Bank and OECD marked to market their respective outlooks for global growth prospects, with downward re-ratings for 2022 coming in response to the shock of the war in Ukraine and its associated amplification of inflation pressures. As the year has progressed the outlook has deteriorated and become more uncertain; the World Bank cut its latest forecast for global growth in 2022 to 2.9% from the 4.1% pace anticipated back in January, while the OECD's projection has fallen to 3% from 4.5% in December.
This represents a sharp slowdown from 2021 when lockdown reopenings generated a 5.7% expansion in global GDP. Although it is not the base case for either group, the World Bank and the OECD warned of the risk of global stagflationary conditions if the war in Ukraine has a more adverse impact on growth and causes inflation to remain elevated for longer than anticipated. Also cited was the risk that interest rate hikes by central banks across the globe could tighten the screws on economies through 2023 to a larger extent than envisaged.
Current conditions according to the latest global PMIs indicated economic growth was holding up in expansionary territory in May, albeit at a soft pace. While there were signs that some input cost pressures were easing in the manufacturing sector, input price pressures in the services sector were increasing due to rising energy, materials and wage costs.
S&P Global chart
