Risk sentiment in markets was under pressure over April as bond yields surged on the back of central banks indicating a willingness to do more in response to high inflation, an effort the RBA looks set to join. Growth concerns associated with the Ukraine war and lockdowns in China were also headwinds.
RBA to hike rates in May...
Rates markets now expect the RBA to start hiking rates at next Tuesday's May meeting, bringing forward the timing from June following this week's Q1 inflation data. The previous expectation for liftoff in June was largely based around the RBA's guidance on waiting for confirmation that a tightening labour market is generating a pace of wages growth consistent with sustainable 2-3% inflation, with the wages growth data not due until 18 May. However, the repricing has come as headline CPI printed with a 5-handle for the first time since 2008 and as underlying inflation moved above the top of the RBA's target band to a 13-year high.
My own view is that the RBA will hike by 15bps next week, as the May meeting will allow the Board to recalibrate its monetary policy stance to new economic forecasts (published next Friday), while it is also due to make a decision on the reinvestment of maturing bonds acquired under the QE program. From a communications standpoint, this seems a good time for the RBA to start gradually moving the policy rate away from its pandemic low of 0.1% with the economy still performing strongly.
...after inflation accelerated in Q1
Headline inflation lifted from 3.5% to 5.1%Y/Y in the March quarter as the spillover effects from the Ukraine war drove up fuel (11%q/q) and food prices (2.8%q/q), while ongoing supply constraints added further to housing construction costs (5.7%q/q). A broadening of price pressures amid strong domestic demand conditions saw the trimmed mean (or underlying) pace up at 3.7%Y/Y from 2.6%. (Full review of the CPI report is available here)
In a global context, Australian inflation pressures have been more modest than in other comparable economies but there was an acceleration in the March quarter. Disruptions to supply chains and higher commodity prices lifted the inflationary impulse from food significantly and increased the contribution to CPI coming from fuel. Australia's very large residential construction pipeline is leading to materials and labour shortages, and with government stimulus grants fading, housing construction costs are a major driver of inflation.
Excluding the price changes from these more volatile items, Australia's underlying inflationary pulse is being driven by higher goods prices, reflecting the same supply/demand imbalances that has seen goods inflation surge offshore. Underlying goods inflation has jumped from a modest 2.9% to 5.2%Y/Y, its fastest since 2001. This compares with underlying services inflation of 2.6%Y/Y, which is higher than its range over recent years without accelerating in the manner goods inflation has.
Terms of trade boost to support the Australian economy
Whereas some of the RBA's global central bank peers are facing the prospect of hiking rates into concerns over economic growth prospects as high inflation squeezes real incomes, Australia is a net beneficiary of surging commodity prices. In Q1, Australian export prices surged by 18% as the Ukraine war led to price rises in some of the nation's major commodities (coal 32%q/q, iron ore 24.8%q/q, natural gas 13%q/q and rural goods 5%q/q). With import prices up by a comparatively modest 5.1% in Q1, the nation's terms of trade surged in the order of 12% in the quarter. This boost to national income will help insulate demand from higher inflation.
US domestic demand is showing resilience
An unexpected fall in Q1 US GDP growth belied resilience in underlying demand conditions. Real GDP contracted by 0.4%q/q in the March quarter, but the decline was driven by negative contributions from inventories and net exports, with the latter reflecting very large US trade deficits. Excluding these components, final sales to domestic purchasers (incorporating household, business and government demand) lifted by 0.6%q/q, up from 0.4% in Q4.
Household spending lifted by a solid 0.7%q/q, though detailed data showed a slowdown over February and March, with goods consumption contracting in both months. The surge in inflation from higher fuel and food prices looks to have weighed on discretionary consumption. Ahead of next week's Fed meeting, its preferred core PCE inflation rate came in at 5.2%yr in March, still very elevated but down slightly from the prior month.
Meanwhile, the employment cost index — another closely watched measure by the Fed — lifted above expectations rising by 1.4% in Q1 to be up 4.5% over the year. A tightening labour market continues to generate pressure on wages and with concerns this could keep high inflation entrenched, the Fed is all but certain to hike rates by 50bps next week.
Euro area inflation rises further as GDP growth slows
Despite a retreat in energy prices following their war-driven surge, preliminary inflation readings in the euro area showed further increases in April as GDP growth in the first quarter was weighed by the Russian invasion of Ukraine and lingering Covid effects. Headline inflation firmed from 7.4% to 7.5%yr, with rising food, goods and services prices more than offseting a fall in energy prices in the month following government tax cuts. A material rise in the core inflation rate to a record high at 3.5%yr from 2.9% pointed to broadening price pressures in the bloc, with the war and supply chain disruptions contributing factors.
From a growth perspective, momentum in the economy has slowed sharply over the past two quarters after GDP had recovered to its pre-Covid level. First quarter GDP growth was posted at 0.2% following the 0.3% expansion in the final quarter of 2021. The ECB expects slow growth ahead with the war and high inflation weakening confidence and the lockdowns in China posing further risks to supply chains. That is restraining the ECB's guidance on tightening, but markets are priced for the ECB to hike rates at least twice by the end of the year due in response to the inflation pressures.
BoJ remains dovish
A downward revision to the 2022 economic growth outlook in Japan from 3.8% to 2.9% in response to the headwinds from Omicron and the Ukraine war left the BoJ showing no sign it was close to reducing stimulus at this week's meeting. The BoJ's key decisions included a commitment to make daily bond purchase in defence of its yield curve control policy. This led to further weakness in the JPY, which is trading at 20-year lows to the USD.