Headwinds to risk sentiment from a hawkish set of minutes from the Fed and much weaker than expected data in China setback equity markets this week and saw renewed strength in the US dollar. Long-term yields steepened sharply in Europe and the UK as their inflation rates reached new highs. Next week's main event is the Fed's annual symposium at Jackson Hole, with Chair Powell speaking on Friday.
Higher for longer in the US now the question
The key message in the Federal Reserve's FOMC July meeting minutes was that it sees further work in front of it in tightening monetary policy to ensure the return of inflation to its target. Dampening expectations around a pivot to rate cuts in 2023, "some participations" noted that once rates had risen to a "sufficiently restrictive level" it was likely they would need to be kept there for "some time" to chart the course down to 2% inflation. Other members on the committee observed that as rates approached this restrictive level, it would be appropriate to slow the pace of hikes to allow it to assess the effect of tighter monetary policy on growth and inflation. Although it was early days in the transmission of rate hikes into the economy, "many participants" saw the risk that the rapid pace at which rates were being hiked ran the risk of the FOMC overtightening policy, in other words causing a recession.
RBA on track to hike rate by 50bps in September
The RBA's August meeting minutes noted the decision to hike rates by 50bps was taken to continue the Board's progress in "normalising monetary conditions". The Board said it was walking a narrow path in hiking rates to curb inflation amid an uncertain growth outlook. Because of upcoming rises in household energy prices, the RBA expects the peak for Australian inflation won't come until Q4, by which stage the pace is anticipated to be pressing 8%. Much of the work in lowering inflation will be seen in 2023, as tighter monetary policy moderates demand and a resolution of supply constraints sees inflation slowing to 3.8%. From there, however, the RBA asserts that the labour market will take over from pandemic-related supply/demand imbalances as the main driver of inflation.
The RBA appears confident inflation will slow next year but stickier inflation pressures emerging from the strong labour market pose risks for a return to the 2-3% inflation target band further out. Given the lags in the transmission of monetary policy, the increasing inflation pressures and the rapidly tightening labour market to my interpretation have prompted this accelerated effort to normalise rates, leading also to the RBA elevating the volume in its commentary around keeping inflation expectations in the target range.
It was thus a pivotal week domestically as we received updates on the labour market and wages growth. Employment was unexpectedly weak falling by 40.9k in July, though that looked to be driven by temporary seasonal factors and Covid-related disruptions. A fall in the unemployment rate to a new half-century low at 3.4% and declines in broader underemployment (6%) and underutilisation (9.4%) reflect the underlying strength in the labour market (full review here). The headline Wage Price Index came in at 0.7% in the June quarter and 2.6% over the year, both a touch softer than consensus (full review here). Wages growth remains subdued relative to the strength of the labour market, though for the RBA the trajectory will matter more than Q2's update. By the end of the year, the RBA forecasts wages growth to be at 3%, rising to 3.6% in 2023 and firming further in 2024. Softer data this week could open the door to a downshift in the pace of RBA hikes, though I tend to think a 50bps hike in September looks more likely.
Inflation pushes higher again in the UK and Europe
UK and euro area inflation made new highs this week as the impact on energy and food prices from the war in Ukraine continues to flow through to both economies. Headline CPI inflation in the UK lifted to double digits coming in at 10.1% in July from 9.4% in June, while core CPI was 0.4ppt firmer at 6.2%. The euro area's inflation rates were squared away at 8.9% in headline terms and 4% on the core rate in July's final estimates.
In both economies, roughly two-thirds of the annual inflation rate is accounted for by energy and food prices. However, inflation pressures are broader than from these sources, reflected in core inflation running well above the targets of the ECB and BoE. The ECB's Executive Board Member Isabel Schnabel in a Reuters interview spoke of the uncertainty that surrounds the inflation outlook and the difficulty its models have had in forecasting inflation. In that sense, Schnabel made the point it would be prudent for the Governing Council to give greater weight to the actual inflation data in its policy decisions.
Reflective of the tightening in the UK labour market with the unemployment rate holding at 3.8% in June, nominal wages growth showed an uptick to 4.7%yr (5.1%yr ex-bonuses), though in real terms the fall has been very significant (-2.5%yr) and this is the basis for the BoE forecasting a recession to fall by the end of the year. Amplifying the headwinds, on the back of this week's labour market and inflation data, markets have firmed up their pricing for rate hikes of 50bps at each of the September and November meetings, while pricing for the peak in Bank rate has lifted to around 3.6% from around 3.3% a week ago.