The latest inflation readings in most major economies continued to surprise on the high-side of expectations, but financial markets are starting to look towards when central banks may pivot and hike interest rates at a less aggressive pace. Essentially, the view that central banks may moderate the size and pace of rate hikes is driven by an assessment that the quick and large interest rate hikes to date, combined with mounting cost-of-living pressures will drive some economies in to recession. While there are signs of slowing global economic activity ahead, several key economic indicators remain stubbornly strong, notably retail spending and the labour market indicators.
While inflation in goods prices may be past its peak, the prices of many services continue to escalate. Peak annual inflation estimates continue to be raised higher while estimates of how far and quickly inflation will fall in 2023 and 2024 are being revised higher. While central banks may pivot towards smaller rate hikes, we see a risk that official interest rates may need to stay at their peak, once reached, for longer.
In the US, Q3 GDP growth was stronger than expected, up 2.6% annualized after contracting 0.6% in Q2. Domestic sales were strong, but with consumer spending lifting at 1.4% annualized pace, moderating from 2.0% in Q2. The latest monthly economic readings from the US show mostly soft leading indicators of activity. Almost all indicators of housing activity are falling. The October National Association of Homebuilders’ Index was very weak at 38 down from 46 in September. September housing starts, -8.1% m-o-m; existing home sales, -1.5% m-o-m; new home sales, -12.4% m-o-m; and pending home sales, -10.2% m-o-m.
In contrast, personal spending in September was firm, up 0.6% m-o-m after a similar gain in August. The key lagging indicator of US economic activity, the labour market, remains very firm. September non-farm payrolls rose 263,000 with the unemployment rate at 3.5%, a near 50-year low, and average hourly earnings up 0.3% m-o-m, 5.0% y-o-y. Despite cost-of-living pressures US households are still fit to spend with firm income growth and drawing down high savings.
US wage pressure remains high enough to ensure that even when high inflation starts to recede (the CPI was stickier than expected in September, +0.4% m-o-m, +8.2% y-o-y, with the core CPI, excluding food and energy prices, +0.6% m-o-m, +6.6% y-o-y), annual inflation is unlikely to move below 4%, let alone approach the Fed’s 2% target over the next two years. This week, the Fed at its policy meeting is expected to hike the Funds rate 75bps to 4.00%. The Fed may pivot to smaller hikes beyond, but the peak for the Funds rate, once it arrives, could stay in place for a protracted period.
In China, the usual run of data releases was delayed during the Peoples’ Congress meeting. That meeting extended President Xi’s term another five years and confirmed China’s unification ambitions with Taiwan and its economic policy priorities – continuing crackdown on corruption and economic activities at odds with Chinese socialism, and lockdowns to contain Covid outbreaks. After the meeting, when the September indicators and Q3 GDP data were allowed to be released, they showed an economy rebounding a little more strongly than expected in Q3, GDP up 3.9% q-o-q, 3.9% y-o-y from -2.6% q-o-q, 0.4% y-o-y in Q2 when lockdowns were most extensive. The September readings showed some improvement in fixed asset investment spending, +5.9% y-o-y from +5.8% in August, and industrial production, +6.3% y-o-y from +4.2%, but deterioration in exports, +5.7% y-o-y from +7.1% in August and notably retail sales, +2.5% y-o-y from +5.4%.
Whatever the directives from the authorities, China’s growth rate seems set to languish beset by weakening global economic growth hurting export growth and local covid containment policies and crackdowns on various activities deemed anti-socialist by President Xi making Chinese households more reluctant to spend.
Europe is moving close to recession. The latest October manufacturing and services purchasing managers indices moved further below the 50 expansion/contraction marker at respectively 46.6 and 48.2. August retail sales were down by 0.3% m-o-m after falling 0.4% in July. While Europe’s unemployment rate is still low at 6.6%, businesses and consumers are becoming much more reluctant to spend because of concerns about the Ukraine conflict, the energy supply crisis heading towards winter and mounting cost-of-living pressures.
Europe’s annual CPI inflation rate at 9.9% y-o-y is expected to push above 10% when the preliminary October reading is released this week. In the UK, annual inflation topped 10% in September and continues to rise. The ECB had to hike its official rates by 75bps at its October policy meeting taking the deposit rate to 1.50%. The Bank of England tried to pivot to smaller hikes, but this week may be forced to deliver a 75bps hike taking the base rate to 3.00%.
Because of high annual inflation still to peak, the ECB and Bank of England are hiking rates making recession all but unavoidable for the EU and UK.
In Australia, housing activity, the most interest rate sensitive part of the economy, is weakening. House prices are falling at the fastest pace in 40 years. In August, the value of housing finance commitments was down by 3.4% m-o-m and down by 12.5% y-o-y and more monthly reductions lie ahead as less home buyers find the amount they can borrow reduced. Housing looks set to continue to weaken, notwithstanding potential lift in demand from rising immigration.
Beyond housing, other parts of the economy remain strong. Retail sales rose in August by 0.6% m-o-m, and 19.6% y-o-y. While higher borrowing interest rates are cutting in to demand to purchase houses, strong retail spending seems to have been immune to rising interest rates so far. Higher mortgage borrowing interest rates hit household budgets with a lag of several months, so the effect of more constrained household budgets may be in the pipeline. The spending catch-up effect after the lifting of covid restrictions also seems to have been very powerful and long lasting in Australia. It has been assisted by high household savings during covid restriction providing a spending war chest, plus until recently very rapid employment growth and very low unemployment. Annual wage growth according to the wage price was only 2.7% y-o-y in Q2 but the total wage bill (including the impact of more people in work) rose by 7%.
Growth in Australian domestic demand, primed by strong household consumption spending continues to stretch supply of goods and services contributing to high inflation. The new Federal Government’s Budget, delivered this month, does not seek to constrain demand. The forecast underlying budget cash deficit increases from an actual outcome of -$A32.0 billion, or -1.4% of GDP in 2021-22 to forecast -$A36.9 billion, or -1.5% of GDP in 2022-23 and -$A44.0 billion, or -1.8% of GDP in 2023-24. These forecasts imply net government spending underpinning aggregate demand.
The RBA needs to dial back growth in aggregate demand to contain and reduce inflation. The RBA also wants to avoid tipping the economy in to recession if it can help it. The Q3 CPI indicates that inflation is running higher and is more broadly based than forecast by both the RBA and Treasury. The Q3 CPI was up 1.8% q-o-q, 7.3% y-o-y with underlying (trimmed mean) inflation up 1.8% q-o-q, 6.1% y-o-y. Beyond Q3, the latest big increases in petrol prices (with excise change); grocery prices; electricity and gas prices; and housing rents are all likely to push up inflation in Q4, and higher than previously forecast. Treasury and the RBA may need to push up their peak annual inflation forecasts from 7.75% above 8%.
The RBA seemed to pivot to smaller cash rate hikes at its October policy meeting delivering 25bps to 2.60%. It may try and stay small this week delivering another 25bps to 2.85%. However, inflation is running higher than previously forecast implying a need to keep hiking the cash rate in December and early next year. We are penciling in a peak cash rate of 3.35% early next year, but with no great confidence. We are becoming more confident that whatever the cash rate peak is next year it will linger for longer because inflation is becoming stickier at higher levels for longer.