Ahead of next week's Federal Reserve meeting, markets have responded to the tightening US labour market and high inflation by lifting to 4 the number of rate hikes anticipated in 2022, with the first of those seen in March, while balance sheet reduction is also likely to commence later in the year. Notably, inflation expectations have eased of late indicating that tighter policy will gain traction in slowing price pressures, leaving real yields to push up benchmark bond rates — a headwind for risk assets. US 2-year and 10-year nominal bond rates now sit close to their pre-Covid highs. Domestically, markets forecast the RBA to start hiking rates by June, with cash rate futures pointing to the policy rate reaching 1% by the end of the year. That is a vastly more aggressive path than was being discussed by Governor Lowe in his recent speeches where there was explicit push back to rate hikes in 2022.
But before the RBA gets to the point of discussing rate hikes, the future of the QE program is to be the main decision taken at Board's February meeting. Though this week's labour market data for December (full review here) pre-dated the Omicron wave, with spare capacity being rapidly absorbed it looks increasingly likely that the RBA will discontinue the $4bn of weekly bond-buying it has been running since September. Following the reopening surge in November, Australian employment continued to rise with a 64.8k increase posted in December (vs 60k expected), which together with eased restrictions supported another sharp expansion in hours worked (1%m/m). From a Delta-lockdown peak of 5.2%, Australia's unemployment rate has come all the way in to 4.2% in December, its lowest since August 2008. Broader measures of labour market underutilisation also fell to 13-year lows. For context, the RBA was not expecting this level of unemployment to be reached until Q4 this year. Weakness in conditions associated with Omicron is likely to be temporary given the resilience shown in the Westpac-Melbourne Institute's consumer sentiment index in January and the strong fundamentals in the labour market with job vacancies elevated and the participation rate sitting just off its record high at 66.1% in December. The effects of a tight labour market on wage and price dynamics is the key focus for policymakers in 2022 and after the upside surprise in Q3's inflation data led to the abrupt end of the RBA's 3-year yield target, next week's Q4 CPI report will be a highlight event.
In Europe, the account of the ECB's December meeting outlined caution and uncertainty around the inflation outlook. This came as euro area headline inflation was confirmed to have risen at a 5% annual pace to December. At that meeting, in response to an economic recovery gathering pace and rising inflation, the Governing Council announced its tapering schedule that will see asset purchases dialled back from a monthly pace of €80bn to €20bn by October. While the ECB expects inflation pressures to ease through the year, a scenario of "higher for longer" inflation persisting in 2023 and 2024 was discussed. How the outlook evolves will depend on the easing of supply/demand imbalances, but ultimately the ECB sees wages growth as the key influence on inflation. For the time being, wages growth was subdued at around 1.5%Y/Y, but the Governing Council noted that this was a lagging indicator and the longer inflation remained high, the more risk there was that wage and price pressures would build and potentially become entrenched. In the UK, inflation became more elevated in December reaching a 30-year high at 5.4%Y/Y on a headline basis, while the core rate lifted from 4% to 4.2%Y/Y. Due largely to a forthcoming reset of household energy prices, inflation is unlikely to have peaked yet and this sees markets widely expecting the Bank of England to hike rates by 25bps at its February meeting to follow up its initial 15bps hike in December. Adding weight to that expectation was a tightening in the labour market, with the unemployment rate falling close to its pre-pandemic level at 4.1% for the 3-month period to November.
