Recession feared previously to start as early as the current northern hemisphere winter starting in Europe and in the US not long after has been delayed by warm winter weather in Europe containing energy prices, optimism that central banks are near the end of their rate hiking cycle as inflation decelerates, and China’s policy makers switching from tough restraints relating to covid and several big sectors of the economy most notably on property speculation to swift re-opening and support. High annual inflation rates have started to fall in the US and Europe adding to optimism that if recession still lies ahead, it is likely to be shallow and with a quick recovery as central banks find themselves in a position to start cutting official interest rates from later this year.
Optimism has been fanned by economic readings through January that mostly have not been as soft as expected with inflation at or lower than expected. Australia and New Zealand have been notable exceptions on the inflation front where annual rates are still rising and are still coming in higher than expected. Even where annual inflation is receding the growing optimism about the economic outlook may prove to be premature if central banks stick to their guidance of doing “all that it takes” to get inflation down to their targets.
Labour markets are still exceptionally tight almost everywhere according to the latest reports from the US, Europe and Australia. Annual wage growth is running at rates that are at, or are threatening to run at, a pace that will not allow inflation to come down to target consistently over the next few years. Central banks may choose to change their guidance focusing more on the deceleration in annual inflation and emphasising less the need to get back to target inflation. This is the circumstance that might ratify current optimism that central banks are close to the end of the current rate hiking cycle.
Such a change in central bank guidance is possible, but it would come with the risk that inflation beyond the current deceleration phase bases higher than target and starts to accelerate again. It is unlikely that central banks will want to risk above target inflation becoming entrenched and we see their guidance sticking with the “doing whatever it takes” line. That means central banks will need to see some easing of tight labour market conditions before they can call time on rate hikes.
In the US, the pace of economic growth is slowing, but not much. The advance reading of Q4 2022 GDP showed 2.9% annualised growth from 3.2% in Q3 and with still good support from real consumer spending, 2.1% annualized growth in Q4 from 2.3% in Q3. Leading indicators of economic US economic activity released in January point to recession but the signals are less pronounced than they were a month or two ago. In contrast, US retail sales have weakened late in 2022 falling 1.1% m-o-m in December after a 1.0% fall in November. Adding to the picture of mixed-strength US economic readings, non-farm payrolls continue to rise strongly, up 223,000 in December, causing the unemployment rate to fall from 3.6% in November to 3.5% in December, matching the lowest reading since 1969 and a marker of an exceptionally tight labour market.
US annual wage growth appears to have peaked and average hourly earnings were up 0.3% m-o-m allowing the annual wage growth rate to fall to 4.6% y-o-y from 4.8% y-o-y. The pressure in the tight labour market makes it unlikely that wage growth will be consistently less than 0.3% m-o-m over coming months which implies that it is unlikely annual wage growth will decelerate much below 4% y-o-y over the next year or two, too high a rate of wage growth to permit inflation to recede to the Federal Reserve’s 2% target over time.
US CPI inflation has been decelerating from its peak above 9% in mid-2022 and in December showed a fall of 0.1% m-o-m taking the annual inflation rate down to 6.5% y-o-y from 7.1% in November. Lower than expected winter energy prices and unclogging international supply chains are helping to drive US inflation lower assisting the base effect that is likely to see further marked reductions in the annual inflation rate over the next few months. The Federal Reserve meets later this week and after hiking the Funds rate 50bps to 4.50% at its mid- December meeting is expected to step back the pace and hike 25bps to 4.75%. In our view, we still see the Fed tempering comments on the welcome reduction in US annual inflation with a warning that tight labour market conditions indicate that the inflation fight is not yet won and that more rate hikes are likely.
In China, economic data released in January were all firmer than expected although still pointing to growth well below long term trend. Q4 2022 GDP was flat in the quarter with annual growth decelerating to 2.9% y-o-y from 3.9% in Q3. December readings showed fixed asset investment spending up 5.1% y-o-y (November 5.3%); industrial production up 1.3% y-o-y (November 2.2%); and retail sales down 1.8% y-o-y (November -5.9%). On the international trade front, December exports were down 9.9% y-o-y (November -8.7%) and imports were down 7.5% y-o-y (November -10.6%). December saw the beginnings of China reducing restrictions and introducing more growth friendly policies. The changes in policy direction, while potentially positive for the growth outlook have come at a price. China’s covid infection rate has soared with the removal of lockdown restrictions.
A few months ago, Europe was tipped to slide in to recession in the northern winter months amid a worsening energy supply and price crisis. A much warmer than usual winter plus better access to energy supplies derailed the energy crisis and has allowed the European economy to continue growing. Leading economic indicators, while still soft, have lifted a little. Europe’s unemployment rate at 6.5% is the lowest this century and still marks a very tight labour market. Annual inflation appears to have peaked above 10% y-o-y and was down to 9.2% y-o-y in December. While the onset of recession has been delayed it is still likely to occur as both the European Central Bank and the Bank of England have become among the more strident talking about the need to contain inflation. The ECB and Bank of England both meet later this week and are expected to deliver 50bps rate hike taking the ECB deposit rate to 2.50% and the Bank of England Base Rate to 4.00%. These expected rate hikes will not be the last given widespread industrial disruption throughout Europe calling for higher wages.
In Australia, most economic indicators released in January, other than those related to housing activity, remained strong. Annual inflation is still rising and a little more than expected. The Q3 CPI rose by 1.9% q-o-q, lifting annual CPI inflation to 7.8% y-o-y from 7.3% in Q3. The underlying inflation measures removing some of the volatile items were also surprisingly high with the trimmed mean up 1.7% q-o-q lifting the annual rate to 6.9% y-o-y from 6.1%.
Another sign that inflation is yet to peak came with the monthly CPI reading for December showing annual inflation lifting to 8.4% y-o-y from 7.3% in November. High Q1 inflation readings in 2022 mean there is a strong likelihood that Australian annual inflation will start to moderate in Q1 2023, but probably not by much.
Essentially Australian demand remains very strong continuing to challenge supply even as that improves with lessening supply chain issues. Australian households were still spending freely in Q4 with post lockdown freedom to spend aided by past savings and strong income growth trumping the impact of rising borrowing interest rates for the time being. In November retail sales jumped 1.4% m-o-m. Demand for Australian exports remains strong with Australia well positioned to provide more food and energy where both are periodically in short supply. China’s relaxing of import controls on selected Australian exports adds to an already bright Australian export growth picture.
Relatively strong Australian demand may be challenged as the lagged impact of the RBA’s interest rate hikes continue to feed through. At present, weakness is confined to housing activity, but that is expected to broaden to more general household spending as the pressure from rising borrowing interest rates continues to bite.
Turning to the outlook for official interest rates, because inflation is so high for the RBA to call time on rate hikes it needs to see not only slowing growth in household spending but also evidence of easier labour market conditions making it less likely that wages will rise at a pace that underpins inflation above 3% for the foreseeable future. The hint of labour market softness in December when employment slipped 14,600 but the unemployment rate remained at a very low 3.5% will not convince the RBA that exceptionally tight labour market conditions are abating. Next week, the RBA meets for the first time this year and is almost certain to deliver at least a 25bps rate hike (the high Q4 and December CPI readings point to risk of a 50bps hike) to 3.25%. The data combinations the RBA needs to see – weak retail sales; unemployment rate rising towards 4%; annual wage growth stabilising around 3.5% y-o-y – are unlikely over the next few months and that means at least one more rate hike beyond what the RBA delivers in February plus an extended stay at the cash rate peak. We pencil in a new cash rate peak of 3.85% that is unlikely to be reduced until early 2024.
Australia is an example of the split between soft leading economic indicators and surprisingly strong coincident and lagging indicators threatening to keep inflation too high for too long. Housing activity at the leading edge continued to weaken in November under pressure from higher borrowing interest rates. House prices are falling at the fastest pace in 40 years. In September, the value of housing finance commitments was down by 8.2% m-o-m and down by 18.5% y-o-y. September home building approvals were down by 5.8% m-o-m and were down by 13.0% y-o-y. As more fixed-rate home loans written in 2020 and 2021 come up for renewal over coming months and the RBA hikes the cash rate at least two more times, housing activity looks set to weaken further.
There is little sign yet of the weakness in housing feeding through to softer retail spending. The opposite is true with retail sales up 0.6% m-o-m in both August and September. While much of Australia’s high inflation problem is supply-shock driven, overly-strong demand is making a contribution too. At this stage, the Q3 GDP report due next week, is likely to show at least 0.5% q-o-q real GDP growth with domestic demand the main support and running closer to 1.0% q-o-q. q.
Australian labour market conditions remain strong. Employment rose 32,200 in October (over the year ending October employment is up 762,000 or 5.9% y-o-y!). The unemployment rate fell to 3.4% in October, the lowest reading since 1974. The Q3 wage price index rose a little more than expected and was up 1.0% q-o-q lifting annual wage growth to 3.1% y-o-y from 2.6% in Q2. We see a high probability that annual wage growth will accelerate above 3.5% y-o-y, the pace the RBA sees as consistent with returning inflation to 2-3% target range, by mid-2023.
Readings released in November of demand in the Australian economy and the strength of the labour market have all been a touch higher than would be consistent the latest RBA economic forecasts released in the RBA’s Monetary Policy Statement early in the month. Those forecasts were sufficient for the RBA to herald that further rate hikes would be needed over coming months. Although the RBA has managed to go against the grain of big rate hikes still being delivered overseas by hiking 25bps in both October and November, Australian data reports covering strength of demand in the economy and labour market strength point at the very least to the need to continue hiking rates. At this stage, we are penciling in another 25bps rate hike to 3.10% next week and a further 25bps hike to 3.35% at the first RBA policy meeting of 2023 in early February. The risk is that more rate hikes may be needed beyond February.