New insights from the Fed supporting larger rate hikes and a rapid reduction of its balance sheet weighed on risks assets through the week but led to the yield curve steepening after its recent inversion and boosted the US dollar. In Australia, the RBA's hawkish pivot has firmed expectations for a June lift-off in the cash rate.
RBA looks set to commence hiking the cash rate in June
The RBA left the cash rate unchanged at 0.1% but the patient stance that has guided the Board's messaging on hiking rates since it started the process of removing pandemic policy support in November was retired at this week's meeting, signifying a hawkish tilt with inflation pressures building. Following the earlier withdrawal of the 3-year yield target and winding up of QE, the RBA has been reluctant to move to raising rates in response to higher inflation in the absence of an acceleration in wages growth from a tightening labour market. But with the RBA's inflation forecasts set to be revised higher in May due to the spillover effects from the Ukraine war on petrol prices and supply chains, the Board no longer feels its patient message is appropriate.
Governor Philip Lowe's decision statement continued to highlight the importance of labour costs picking up to sustain inflation in the 2-3% target band and notes the Board will be watching closely the relevant data "over coming months". In response, the consensus has firmed on June as the timing for the first rate hike, though economists favour a 15bps increase to 0.25% whereas markets are moving to price in a larger 40bps hike to 0.5%. Markets are also more aggressive on their call for where the cash rate will end 2022 at around 2% compared to 1% or just above for economists. For more on Tuesday's RBA meeting see here. Meanwhile, the RBA's semi-annual Financial Stability Review reported many households have built up substantial buffers on their mortgages over the Covid period, though higher debt levels had increased the sensitivity of spending to higher interest rates.
Australia's trade surplus narrowed in February
A 12.1% surge in import spending led to a sharp narrowing in the trade surplus to $7.5bn in February (reviewed here). Rising imports were driven by consumption goods (16.5%m/m), reflecting the strength of domestic demand conditions, and intermediate goods (16.9%m/m) on the back of higher petrol and input prices. Exports held flat in the month but are expected to accelerate due to the Ukraine war pushing up the prices of the nation's key commodities.
Also out this week in Australia, retail sales were confirmed to have risen at a solid 1.8% pace in February, led by a 4.8% acceleration in spending across the discretionary categories (reviewed here). The data confirmed that robust spending was still occurring despite the weakening in consumer sentiment measures of late. In the labour market, the latest reading from the ABS's high frequency payrolls index showed a softening over the month to mid-March (-0.6%) but was attributed to the disruptions from floods in New South Wales and Queensland.
A hawkish Fed outlined its plan for balance sheet reduction
Recent comments from Fed officials following the mid-March meeting had clearly conveyed the need for a more aggressive policy response to high inflation, with a speech from Governor Brainard early in the week continuing that theme. The hawkish messaging from FOMC members reflected a broad consensus around the Committee table that was revealed in the meeting minutes, published this week. The key developments were that "many participants" would have preferred to commence the rate hiking cycle with a larger increase of 50bps but were held back by the Ukraine war, settling on a 25bps increase instead, while the pace of balance sheet reduction is set to occur at almost double the pace of the previous episode in 2017-19.
Consistent with earlier post-meeting commentary, the minutes noted "many participants" assessed that "one or more 50 basis point increases" in the policy rate may be needed if inflation pressures "remained elevated or intensified". On the balance sheet, the Fed as part of normalising policy needs to tighten financial conditions, which were being eased by its large-scale bond purchases since the outset of the pandemic. This will be achieved by allowing maturing bonds to roll off its $9tn balance sheet, with the pace of reduction planned to be phased in over a 3-month period (expected to start in May), working up to $60bn/mth for US government bonds $35bn/mth for mortgage-backed securities (MBS). Sales of MBS will be considered later down the track. That plan would equate to $95bn/mth of balance sheet reduction, which compares to a peak pace of $50bn/mth in 2017-19, the only other occasion the Fed has attempted quantitative tightening.
ECB's Governing Council settled on a compromise in March
With inflation surging and the Ukraine war denting growth prospects in the euro area, the ECB's Governing Council settled on what was described in the account of the March meeting as a "balanced compromise". The hawkish members had pressed for a "firm end date" on QE sometime in the summer to pave the way for rate hikes in the third quarter so as to avoid the risk of "falling behind the curve" on inflation. However, the doves argued for a "wait-and-see" approach given the uncertainty posed to the economic outlook by the Ukraine war.
In the end, a more accelerated tapering of QE was announced, though optionality has been retained that could allow for purchases to be extended into the third quarter, while it also altered its guidance for rate hikes by noting they would occur "some time after" the end of QE in an attempt de-link the two. Going into next week's meeting, the acceleration in inflation to record highs for both the headline (7.5%) and core rates (3%) in March will give the hawks more fuel to push for a more aggressive response.