With Australia's underlying inflation rate coming in stronger than expected at 7-year highs and following the significant tightening seen in the labour market, an interesting RBA meeting is in prospect in the week ahead. The RBA's QE program looks set for a mid-February conclusion while an upgraded set of economic forecasts could support a case for rates to start rising later in the year, well ahead of current guidance. Cash rate futures continue to factor in as many as 4 hikes in 2022, but for the RBA an acceleration in wages growth is a precondition and key to the start date. The data this week showed December quarter inflation printed at 1.3% on the headline measure to be running at 3.5% over the year, while the underlying rate was up at 2.6%Y/Y after posting its strongest quarterly rise (1%) since 2008 (full review here).
Around half of the contribution to annual headline inflation has come from higher fuel prices and rising housing construction costs. The latter has come about due to materials and labour shortages amid a surge in dwelling commencements, while the closure of the HomeBuilder scheme earlier in 2021 means fewer subsidies are now being paid to offset construction cost increases. Pandemic-related factors also influenced inflation in Q4 on reopenings from the Delta lockdowns. Domestic (4.8%) and international travel (16.3%) costs elevated as border restrictions started easing; restaurant prices (1%) lifted in response to higher input costs; while demand and supply imbalances have pushed up the cost of many consumer durable items. While many of these increases are related to the pandemic and should eventually ease, the rise in trimmed mean inflation to 2.6%—the first time the measure has been above the midpoint of the RBA's 2-3% target since 2014—suggests there is now a broader range of effects leading to higher prices. The RBA's interpretation of these dynamics will shape their outlook on policy to be outlined next week.
The December NAB Business Survey reported a sharp fall in confidence (+12 to -12) as Omicron started to spread widely; conditions were holding up for now (+11 to +8) but are expected to weaken in the next survey reflecting the disruption to activity from caseloads and isolation requirements. Indications are that this will put more upward pressure on inflation in Q1, with the December survey highlighting increased labour, input and product prices. Pressure on input costs was evident in Q4 as import prices advanced by more than 5% for the second consecutive quarter and producer prices lifted by 1.3%q/q to their fastest annual pace (3.7%) since 2009.
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Over in the US, in spite of the ongoing reverberations in risk sentiment, Fed Chair Jerome Powell validated market expectations at this week's FOMC meeting, classifying 2022 as a year in which emergency pandemic settings will be steadily removed. The Committee was true to its earlier guidance in maintaining a March expiry on QE but has markets primed for that to coincide with the first rate hike. The overarching message from Chair Powell at the post-meeting press conference was that curtailing high inflation was crucial to sustaining the economic expansion underway. That expansion now sees US GDP 3.1% above its pre-pandemic level following a 1.7%q/q acceleration in output in Q4. Unlike in previous cycles, Chair Powell said that such was the degree of tightness across a broad range of indicators, a robust labour market could be sustained alongside a path of higher rates. Up to 5 hikes are priced into the forward curve in 2022 ahead of reaching a terminal rate of around 1.8%. The other aspect of this tightening cycle is that the Fed will also be reducing the size of its balance sheet. While the details are yet to be determined, the Fed published alongside this week's policy decision a set of guiding principles for balance sheet reduction.
Regarding inflation, Chair Powell said a reduced fiscal impulse, less accommodative monetary policy, and some relief of supply constraints should help ease price pressures this year. In December, 12-month core PCE inflation firmed from 4.7% to 4.9%, its highest since 1983. This exceeded annual growth in the employment cost index to Q4 (4%) and there are signs this is weighing on spending. Real personal consumption growth posted its weakest outcome in 10 months with a 1% fall in December. This was driven by weakness in goods consumption (-3.1%m/m) as services were broadly flat (0.1%m/m) despite Omicron. Given the disparity between goods (8.8%Y/Y) and services inflation (4.2%Y/Y), elevated price pressures look to be weighing on demand in the former.
Other events of note this week underscored the uncertainty markets are currently struggling with. The IMF cut its forecast for global growth in 2022 from 4.9% to 4.4% in its January Outlook citing reduced fiscal support in the US and pandemic restrictions and stresses in the real estate sector in China as the headwinds. This came as the impact of Omicron was reflected in the slowing of the PMIs for the euro area (52.4 from 53.3) and UK (53.4 from 53.6) to 11-month lows in January. Restrictions and precautionary behaviour had weighed on consumer-facing industries in hospitality, tourism and leisure. However, the PMIs were still at levels consistent with expansion and activity looks to have been more resilient to the pandemic than in previous waves. There were also encouraging developments in the manufacturing sector where some of the pressures in supply chains from materials shortages and delivery times had eased. But for the time being, inflation is at elevated rates in both economies and the ECB and BoE have policy meetings next week. Little change is expected at the ECB after its tapering schedule for QE was announced in December, but over at the BoE, a 25bps hike is expected as a follow up to the initial 15bps increase delivered at the previous meeting. This would take Bank Rate to 0.5%, the level at which the BoE has said will see it commencing the process of reducing its balance sheet.
