In June central banks confirmed that they remain determined to get high and sticky inflation down to their targets even as growth weakens, and some economies enter recession. While the US Federal Reserve paused at its June policy meeting it indicated that two more rate hikes are likely to be needed over coming months and that the battle against inflation is far from over. The European Central Bank hiked official rates 25bps with the European economy already in recession while the Bank of England surprised by hiking 50bps with the British economy stalling. In Australia, the RBA after pausing in April, delivered back-to-back 25bps rate hikes in May and June and is indicating that it is not finished. With central banks continuing to hike rates with weak or negative economic growth already evident it is more likely than not that many, including Australia, will experience recession later this year or in 2024.
In the US, most economic reports released in June show slowing economic activity but still with some signs of strength in services and the labour market. Progress reducing inflation has slowed to a crawl and while the prices of goods and fuel are moderating, service prices remain sticky and high. Annual CPI inflation fell to 4.0% y-o-y in May from 4.9% in April, but the core CPI (excluding food and energy prices) sits higher at 5.3% y-o-y and slowed less from 5.5% in April. Stickier core inflation is likely to slow progress getting annual headline CPI inflation lower over coming months. Another factor standing in the way of getting US inflation down is wage growth running too high above 4% y-o-y on all measures.
Americans are experiencing real wage growth and that may work to lift household spending, another impediment to getting inflation down. While US economic growth is running weaker there are only the first hints of weakness ahead in US labour market conditions. Weekly initial jobless claims have lifted to over 260,000 in recent weeks. The latest non-farm payroll data for May, however, was still very strong. Non-farm payrolls were up by 339,000 after lifting 294,000 in April. While the unemployment rate rose to 3.7% in May from 3.4% in April, the rise was driven by an unusually large increase in participation in May, a sign of labour market strength. Even at 3.7%, the unemployment rate is tracking too low to place any downward pressure on wage growth.
The Federal Reserve needs to see an unemployment rate north of 4% and wage growth south of 4% before it can be confident that it can return inflation to 2% target in a reasonable time frame. At this stage the 4% benchmark for the unemployment rate and wage growth are many months away absent a sharp reduction in economic activity. We see the Federal Reserve delivering another two rate 25bps hikes from the current 5.25% funds rate before it is finished for this cycle and then needing to hold the peak rate for several months. Hence the Federal Reserve’s warnings that it still has a long way to go to bring inflation down to target.
In China, economic releases in June show the recovery losing momentum prompting more government spending and modest monetary stimulus from the Peoples’ Bank of China cutting the official interest rate by 10bps to 3.55% last week. May economic readings were softer than expected across the board. Exports were down 7.5% y-o-y after increasing 8.5% y-o-y in April. Fixed asset investment spending rose 4.0% y-o-y (April +4.7% y-o-y), industrial production was up 3.5% y-o-y (April +5.6%), and retail sales were up 12.7% y-o-y (April +18.4%). May purchasing managers’ reports were cheerier with the Caixin versions both above 50, 50.9 for the manufacturing survey and a strong 57.1 for the non-manufacturing, or services, sector report. Past economic weakness in China means it has excess capacity in a world where capacity is mostly very strained. Excess capacity in China has pushed down CPI annual inflation to only 0.2% y-o-y in May with producer price inflation at -4.6% y-o-y.
In Europe, revised Q1 GDP figures showing growth sliding 0.1% q-o-q in both Q4 2022 and Q1 2023 confirm that Europe is in recession and with its biggest economy, Germany suffering the biggest growth decline. The European labour market, however, remains very tight with the unemployment rate at a quarter-century low, 6.5%. The tight labour market continues to drive high wage claims which make it unlikely the European Central Bank (ECB) can engineer a return to low and stable inflation in the near term. As a result, the ECB keeps tightening monetary conditions even though surveys of lending conditions in Europe are pointing to very tight conditions already. At its June policy meeting, the ECB hiked the deposit rate 25bps to 3.50% and is pointing to more rate hikes ahead. In the United Kingdom, suffering higher inflation and wage claims than in Europe, the Bank of England surprised at its June policy meeting by hiking by 50bps taking the base rate to a 15-year high, 5.00%, and indicating more rate hikes ahead to deal with inflation stuck above 8% y-o-y.
In Australia, the pace of economic growth is slowing with real GDP up 0.2% q-o-q, 2.3% y-o-y in Q1 2023 from up 0.6% q-o-q, 2.6% y-o-y in Q4 2022. Much of the slowing pace of GDP growth is coming from decelerating growth in household consumption spending and that appears to be continuing in Q2 with April retail sales flat month-on-month after rising 0.4% in March. May retail sales, out later this week, are expected to be weak again providing evidence that one key and big part of the economy is being dampened by higher interest rates.
Other parts of the economy are proving to be less responsive so far to higher interest rates. Home buying activity has been rising over recent months and because of limited supply of housing has lifted home prices. The labour market remains tight with the May labour force report showing an out-sized 75,900 lift in employment, the participation rate at a record 66.9%, and the unemployment rate falling to 3.6% from 3.7% in April. The tight labour market is placing no restraint on wage negotiations which are all being based on compensation for high inflation. What has so far mostly been high demand in the economy and constrained supply driving inflation is at risk of changing to higher wage growth supporting on-going inflation above the RBA’s 2-3% target band.
While inflation has fallen from its peak for this cycle, the latest monthly CPI reading for April showed a lift in annual inflation to 6.8% y-o-y from 6.2% in March. The May report is due later this week and should show annual inflation falling to around 6.1% y-o-y, or a little less (a function of the way the temporary relief from petrol excise tax impacted petrol prices last year). Around 6% y-o-y inflation is still too high from the RBA’s perspective of getting inflation down to 2-3% target in a reasonable time frame. The RBA is facing a long-haul getting inflation down made more difficult unless labour market conditions and wage setting behaviour show signs of softening relatively soon.
The RBA is watching economic data carefully to determine whether more interest hikes are needed. At this stage, the strength of the labour market, inflation-compensating wage negotiations and rising house prices are trumping the weakness so far in retail spending and are driving the RBA to deliver more rate hikes. They may not be delivered every policy meeting, but we are now penciling in another two cash rate hikes taking the cash rate up to 4.60% in the next few months.