Stresses in the US and European banking systems leave central banks in a difficult place with inflation still elevated. The collective actions of authorities on both sides of the Atlantic to shore up confidence may be sufficient for now: that's if the ECB's decision to push ahead with rate hikes offers any guide to what the Fed and BoE may do at their respective meetings next week. But markets are clearly of the view that central banks are not far away from ending rate hikes on the anticipation that tighter lending conditions will weigh on growth and inflation.
US inflation to retain the Fed's attention
While stresses in regional US banks have cast a shadow over next week's Fed meeting, a 25bps rate hike appears the most likely outcome. That comes after the ECB pressed ahead with hiking rates (see below) and as core inflation surprised to the upside of expectations in the February CPI report. What shapes as the wildcard for next week is what the Fed does with its projection for the peak rate, currently at 5.1%. Only recently, the expectation was that this would be raised to 5.5% but that is now under the spotlight.
In February, headline CPI eased to 0.4%m/m (from 0.5%) but the core rate went the other way to 0.5%m/m (from 0.4%) and remained well above a pace consistent with the Fed's inflation target. Annual inflation continued to unwind from the peaks of last year - headline sliding from 6.4% to 6% and the core rate easing from 5.6% to 5.5% - but progress remains gradual.
Once again, the disinflationary pulse from durable goods was evident (0%m/m, -1.8%yr) but services inflation remained elevated (0.5%m/m, 7.6%yr) and this is holding back the pace of decline in both headline and core inflation.
In news relating to the US consumer, retail sales softened from a very robust start to 2023, with weak outturns coming through for both headline (-0.4%) and core sales (0%). However, a solid rise for control group sales (0.5%) on the back of January's surge (2.3%) suggested household demand retains underlying strength.
ECB presses on
The ECB stuck to its guns and hiked rates by 50bps this week as revised forecasts projected inflation remaining "too high for too long". With the depo rate lifting to 3.0% - still well below the policy rates of many of its global peers - and core inflation remaining on the rise to 5.6%yr in February, the ECB was not dissuaded from hiking by the instability in markets. But this has added a layer of complexity to an already uncertain economic outlook and prompted the Governing Council to shelve forward guidance.
In the post-meeting press conference, President Christine Lagarde said that the ECB was closely monitoring the situation in the banking system and that it could call upon its toolkit of liquidity measures if the circumstances required it to act. When pressed on whether hiking rates to restore price stability would take a back seat to financial stability considerations, President Lagarde said that there was "no trade-off" with each needing to be addressed with a different set of tools.
The ECB's latest macroeconomic projections were revised to show an expectation for higher growth and lower headline inflation in 2023 than previously forecast; however, these projections are heavily caveated having being finalised prior to the emergence of strains in the banking system. GDP growth was revised up to 1% (from 0.5%) before lifting to 1.6% in 2024 and 2025 (from 1.9% and 1.8% respectively). Headline inflation was forecast to decline more quickly this year, easing to 5.3% by year-end (from 6.3%) but core inflation was revised higher (4.6% from 4.2%). Both headline (2.1%) and core inflation (2.2%) are not expected to be back around the ECB's target until 2025.
Australian labour market returns to strength
The Australian labour market regained momentum in February after conditions loosened around the turn of the year. The unemployment rate fell back to half-century lows at 3.5% from 3.7% as employment increased by 64.6k - its largest rise since June-22 - more than rebounding from a 27.5k decline over December and January. With many people returning to work or starting new jobs after the peak summer holiday period, hours worked surged by 3.9% in the month (full review here).
Rising employment and hours worked saw labour market tighten, reversing a recent easing in conditions as both underemployment (6.1% to 5.8%) and total underutilisation (9.8% to 9.4%) declined, the latter falling back to be around its lowest since the early 1980s. A rise in the participation rate to 66.6% - with likely more to come as overseas arrivals enter the labour force - should help keep wages growth rising at a gradual pace and leaves a pause in the RBA's rate hiking cycle on the table at the April meeting.
The expectation for further rate increases, however, kept consumer sentiment at a very weak level (78.5) on the Westpac-Melbourne Institute Index in March. The outlook for both family finances and economic conditions over the year ahead weakened and are around 19% lower than in March 2022; the effect of this deterioration in sentiment was evident in the slowdown in household consumption in the recent Q4 national accounts. Although business conditions in the NAB Survey remained robust in February (+17), a weakening in confidence (-4) highlighted uncertainty over their sustainability going forward.
Bank of England meeting looks finely balanced
Although market volatility and recent comments from Governor Bailey have lowered the bar for pausing rate hikes in the UK, a final 25bps hike could still be in play at next week's BoE meeting. This week's labour market data was strong, with a 65k rise in employment over November-January compared to August-October keeping the unemployment rate around historic lows at 3.7%. Still plagued by an elevated inactivity rate (36.8%) coming out of the pandemic, wages growth remained strong running at an annual pace of 6.5%.
The government's latest budget was framed around an improved economic backdrop, with the growth forecasts revised upwards and the inflation outlook lowered. That provided the government with a windfall of around £25bn per year for the next few years. New measures announced by Chancellor Hunt use around 2/3 of that windfall, with the headline initiatives being expanded access to free childcare and tax incentives to boost business investment. The OBR assessed that this leaves the government with minimal "headroom" (0.2% of GDP) to achieve its main fiscal target for net debt to be falling by the end of the projections in 2027/28.