Risk assets saw some respite with most equity markets advancing after falling heavily in recent weeks. Alongside this, strength in the US dollar strength came off slightly. The US yield curve became a little more inverted as Chair Powell reaffirmed the Fed's commitment to lower inflation. On that front, we saw the ECB and BoC both hiking rates by 75bps this week and in Australia, the RBA raised the cash rate by a further 50bps.
Resilient household demand is driving the Australian economy...
The Australian economy expanded by 0.9% in the June quarter and 3.6% in year-ended terms, maintaining solid momentum against a backdrop of slowing growth offshore in G7 economies and a sharp contraction in China following the return of lockdowns. Domestically, household consumption lifted by 2.2%, contributing 1.1ppts to growth in Q2, a resilient outcome to headwinds that include high inflation and falling real incomes, the RBA's rate hiking cycle and weak sentiment. Also supporting growth was net exports (1ppt) as resources production rebounded from weather-related disruptions and inbound tourism picked up. Supply constraints weighed on growth affecting inventory rebuilding (-1.2ppts) and residential construction activity (-0.1ppt) due to materials and labour shortages. My in-depth review of the Q2 national accounts is available here.
The strength in the labour market and accumulated savings are key factors that continue to support household spending. The full reopening of the international borders also provided a boost, with pent-up demand for travel and associated accommodation and hospitality services coming through. Reflecting this, services consumption advanced strongly (3.6%), continuing the rotation in demand away from goods categories (-0.1%). A 1.3% rise in July retail sales suggests the overall momentum in spending has continued into Q3 (see here).
The run-up in commodity prices following the war in Ukraine and other supply pressures led to the terms of trade rising to a record high, boosting national income and keeping the current account surplus elevated at 3% of GDP in the June quarter (see here). A more recent retracement in prices, however, led to a sizeable pullback in the monthly trade surplus in July (see here).
... as the RBA hiked rates by a further 50bps
The RBA Board hiked rates by 50bps to 2.35% at Tuesday's meeting, taking the amount of tightening delivered since May to 225bps (reviewed here). Governor Philip Lowe's decision statement noted rates were expected to be hiked further "over the months ahead". The reference to "normalisation" that has been used to characterise the earlier rate hikes was removed from the statement with rates approaching estimates of neutral in Australia.
At a speech later in the week, Governor Lowe said the Board was conscious of the lags in the transmission of monetary policy to the economy and also recognised that the case for slowing the pace of hikes was "stronger as the level of the cash rate rises". The central message remained intact that higher rates were required to rebalance supply and demand in Australia and to keep a hold on inflation expectations, but it seems the Board will be open to a discussion in October to slowing the pace of hikes (likely to 25bps increments), dependent on the data flow.
ECB moves to frontload its hiking cycle
The speculation in the lead-up to this week's meeting proved well founded as the ECB hiked its key interest rates by 75bps following on from the 50bps hike in July. The Governing Council noted in its decision it had sped up the pace of tightening to "frontload" the withdrawal of accommodative rate settings given inflation was running "far too high" at 9.1% and was likely to stay elevated for "an extended period". With an updated set of economic projections raising the outlook for inflation materially to 8.1% this year (from 6.8%), 5.5% in 2023 (3.5%) and 2.3% in 2024 (2.1%), ECB President Christine Lagarde said in the post-meeting press conference the Governing Council was prepared to keep hiking rates into 2023.
That tightening will come into a deteriorating economic outlook as Europe confronts a significant real income squeeze and an energy crisis. Forecast economic growth this year has been lowered from 3.1% to 2.8%, slowing sharply to 0.9% in 2023 (down from 2.1%) with a rebound seen in 2024 at 1.9% (from 2.1%). Although the base case is for Europe to avoid recession, President Lagarde said the risks to growth were to the downside and forecasts that used more pessimistic assumptions pointed to a downturn in 2023.
Also of note, with the depo rate lifting off zero, the ECB has temporarily lifted the 0% cap attracted by government deposits held at the ECB. These deposits will now be remunerated in line with the depo rate (0.75%) through April 2023, the move intended to prevent deposits from flowing into the markets and pushing down short-term rates.
Fed Chair Powell sticks to script
In a Q&A appearance, Fed Chair Jerome Powell reaffirmed the commitment emphasized in his recent Jackson Hole speech to prevent high inflation from becoming entrenched in the US. Chair Powell said it was imperative for the Committee to heed the lessons from the high inflationary episodes during the 1970s and 1980s by taking strong action with its policy tools and "keep at it until the job is done". In a similar vein, Fed Vice Chair Lael Brainard said in a speech that it will continue its fight against inflation "for as long as it takes". To have confidence that inflation is falling back to the 2% target, Brainard said restrictive monetary policy will be required for "some time". Next week, CPI data for August is due (13/9) with the market looking for a modest 0.1% fall in month-month inflation.
