The adjustment of central bank policy outlooks to the inflation and growth risks accentuated by the Ukraine war has driven markets this week. Both the Fed and BoE announced rate hikes, while a strong labour market has taken the RBA closer to that point.
Tightening in the Australian labour market resumed after a disrupted start to 2022...
After being held back by Omicron and summer holidays, progress towards meeting the RBA's full employment goal resumed its late 2021 momentum in February. A much stronger-than-expected rise in employment of 77.4k drove Australia's unemployment rate down from 4.2% to 4%, a new low dating back to mid-2008, and January's initially reported increase was revised up from 12.9k to 28.3k (full review here).
Hours worked surged back by 8.9% in February, reversing the 8.6% collapse in January when Covid isolation requirements and annual leave left many firms short-staffed. These latest outcomes left employment (+2.9%) and hours worked (+2.7%) virtually in sync on a comparison with their pre-pandemic levels. As a result, both underemployment (6.6%) and overall underutilsation in the labor market (10.6%) are down at 13-year lows.
The broad-based expansion in the labour market is leading to an increased supply of workers, with the participation rate moving up to a record high of 66.4% in February. Although wage pressures have risen as the labour market has tightened, the overall supply/demand balance has been a key factor in keeping the pace measured relative to the acceleration in wage costs seen in economies offshore, notably in the US and UK.
March's RBA meeting minutes published this week showed the Board was in agreement that with the labour market tightening, the outlook for wages growth was "skewed to the upside", giving further context to Governor Lowe's recent shift that a rise in the policy rate this year was plausible. The time for the Board to start normalising rates away from pandemic settings is clearly nearing (markets have the first hike coming in June), but the more important issues are the pace of tightening through the cycle and the level the cash rate ultimately reaches.
Markets have more than 100bps of hikes priced in this year and see the cash rate peaking just below 2.5% by mid-2023. This continues to look too aggressive given Australia's wage-price dynamics, where it has taken the strains in global supply chains and an extraordinary recovery in the labour market to see inflation return to RBA's target for the first time in 7 years and wages growth at pre-pandemic rates.
In the US, the Fed commenced its hiking cycle and turned more hawkish...
True to recent guidance from Federal Reserve Chair Jerome Powell, the FOMC at this week's meeting announced the liftoff in its policy rate from its pandemic low and signalled a series of further hikes to come over 2022 and 2023. Meanwhile, the preparatory work on the plan for reducing the balance sheet continued and will be announced at "a coming meeting".
The target for the fed funds rate was lifted by 25bps to 0.25% to 0.5% and, undeterred by an expected hit to economic growth this year due to the Ukraine war, the Committee revised significantly higher its median projection for rate hikes in 2022 to a total of 7 (i.e. 6 more) from 3 previously. The median dot then lifts to indicate a further 4 hikes in 2023, taking the fed funds rate to 2.8% (up from 1.6% in December) and held unchanged through 2024 (2.1% previously). Overall, the new projections serve as a signal of intent from the FOMC that it is prepared to move aggressively on rates to bring inflation under control.
That comes about with price pressures having been amplified by the spillover effects from the Ukraine war, pushing up the inflation projections in 2022 from 2.6% to 4.3% for headline and from 2.7% to 4.1% on the core rate. An easing in supply chain pressures and lower energy prices sees inflation declining but still remaining above the Fed's target in 2023 (2.7% headline and 2.6% core) and 2024 (2.3% for both headline and core).
In the post-meeting press conference, Chair Powell said the Committee's assessment was that the US economy was "very strong" and "well positioned" to handle a hiking cycle. Whether or not it can be as aggressive as a straight read of the dot plot implies remains to be seen. A cut in the growth outlook this year from 4% to 2.8% references the impact of the Ukraine war, but the projections for 2023 and 2024 were left unchanged at 2.2% and 2% respectively. The projection for the unemployment rate was also maintained at 3.5% this year and next but was a touch higher at 3.6% in 2024. The flattening in the yield curve (becoming inverted in some segments) indicates that markets are skeptical of the outlook that above-trend growth and a tightening labour market can be maintained as the fed funds rate moves into restrictive territory above the Committee's 2.5% longer-run estimate of the neutral level.
In the UK, the BoE could be nearing a pause on rate hikes...
The Bank of England's MPC this week announced its third rate hike from as many meetings, taking Bank rate up 25bps to its pre-pandemic level of 0.75%, though the sense was a pause on further tightening could be nearing. The vote went 8-1 in the way of hiking by 25bps, with the one dissenting vote in favour of leaving rates unchanged. Compare this to the February meeting where the decision to hike was not only unanimous but the vote at 5-4 fell just short of a larger 50bps rate hike being the call.
A more cautious assessment of conditions has taken shape since the February meeting due to the Ukraine war adding upside risks to inflation in the near term, which is now seen peaking higher at around 8% by the middle of the year, and downside risks to growth through the squeeze on household incomes and spending. Beyond the near-term price rises in energy and goods, the MPC sees that inflation could eventually decline by more than previously expected as growth slows and earlier hikes take effect. Accordingly, the MPC's tone on the need for further rate hikes has softened from being "likely to be appropriate" to now "might be appropriate". Pricing in the forward curve for Bank rate to rise to around 2% by the end of the year looks challenged given this week's developments.
... while the ECB is keeping its options open
ECB President Christine Lagarde's address at the ECB Watchers conference reiterated the key messages from last week's policy meeting. The persistence of high inflation, now amplified by the Ukraine war, had convinced the Governing Council to outline its plan to dial back bond purchases, potentially ending in Q3 if the data allows it. Should the tapering process prove to be problematic, President Lagarde said the ECB could use "a wide range of instruments to address fragmentation".
