While most economic reports from major economies continue to show firm economic activity through the middle months of 2022, recession seems to lie ahead as central banks try to tame high inflation. Bringing inflation back to target is proving to be a difficult challenge in the US where rising service prices are part offsetting the moderating influence on inflation of stabilising goods’ prices, and high wage growth threatens above-target inflation persisting for several years to come. In Europe, the energy supply crisis in the approaching winter seems to imply that recession is imminent coinciding with high inflation requiring the European Central Bank to keep lifting interest rates. Britain’s gamble throwing caution to the wind with the biggest tax cuts in four decades as well as an expensive cap on energy prices has inflation-supporting consequences that mean the Bank of England may need to push up interest rates by more than expected previously.
The global economic outlook is worsening and that will have some negative impact on Australia’s economic growth outlook cushioned to some degree by an unusual combination of a soft Australian dollar exchange rate coinciding with still strong terms of trade. The prices of several key Australian export commodities such as coal, gas, and agricultural goods are holding up well. Australian domestic demand, other than for interest-rate-sensitive housing, also remains firm and the RBA, because of not-quite-so-high inflation locally compared with inflation in most major economies, means that the RBA has less work to do than its peers hiking interest rates. Australia will experience weaker economic growth over the next year, but the downturn should be one of the shallowest by international comparison.
Returning to the US, the economic readings released through September show some signs of softening activity but are still not heralding imminent recession. August housing indicators mostly fell again, other than a quirky 12.2% m-o-m rise in housing starts. August ISM purchasing manager readings for the manufacturing and non-manufacturing (service) sectors of the economy remained above the 50 expansion/contraction marker at respectively 52.8 (52.8 in July) and 56.9 (56.7 in July). August retail sales lifted 0.3% m-o-m but coming after July retail sales were revised lower to -0.4% m-o-m. August industrial production fell 0.2% m-o-m.
While most US economic indicators show patchier growth, indicators of the labour market and wage growth remain strong. Non-farm payrolls in August rose by 325,000 after lifting 526,000 in July. A rise in labour force participation led to the unemployment rate lifting to 3.7% in August from 3.5% in July, but wage growth was still high with average hourly earnings up 0.3% m-o-m, 5.2% y-o-y.
Labour market tightness and high wage growth are supporting inflation well above the Fed’s 2% target for the next year or two at least. Worryingly, the latest August CPI at +0.1% m-o-m, +8.3% y-o-y with a core reading excluding food and energy prices of +0.6% m-o-m, +6.3% y-o-y is still showing broader-based inflation pressure than many including the Fed had hoped.
During September, the Fed reaffirmed that it will do what it takes to contain inflation and conceded the possibility that it may need a recession to bring inflation back to target over time. At the Fed’s late-September policy meeting it hiked the Funds rate by 75bps to 3.25% and indicated that the Funds rate may push above 4.50% over the next year and over the next two years may settle in the wake of weaker growth to 3.90%. The message was clear. More big rate hikes ahead and interest rates staying higher for longer to contain inflation. In effect, the Fed has to see lower wage growth caused by rising unemployment before it can take its foot off the monetary policy brake. It is hard to see how the Fed can manufacture a soft landing for the US economy in these circumstances.
Among the major economies experiencing the need to dampen demand even as recession looms to contain inflation, China remains an exception. GDP growth has been slowing over the past year down to -2.6% q-o-q, +0.4% y-o-y in Q2 with only modest rebound likely in Q3. Property development and finance is still reeling in China under pressure from official policies aimed at containing excesses. China’s use of lockdowns in response to small Omicron outbreaks affecting at any one time a sixth and more of China’s population is also clamping demand. Weak demand is keeping a lid on inflation (August CPI 2.5% y-o-y with producer price inflation, 2.3% y-o-y) providing some leeway for the authorities to boost spending and small easing of monetary policy, but August indicators, although mostly firmer, point to annual GDP growth continuing to struggle. August fixed asset investment spending edged up to 5.8% y-o-y (July, 5.7%), industrial production up to 4.2% y-o-y (July, 3.8%), retail sales up to 5.4% y-o-y (July, 2.7%), but exports moderating to 7.1% y-o-y (July, 18.0%).
Europe continues to show relatively strong past economic data but greatest imminent recession risk because of restricted energy supply and high prices related to the Ukraine War. Europe’s inflation rate is high and rising. CPI inflation rose to 9.1% y-o-y in August and is expected to be close to 10% in September. The European Central Bank has started increasing interest rates aggressively including the latest super-sized 75bps hike at its September policy meeting, taking the deposit rate to 0.75%. More big rate hikes are likely even as energy supply constraints mean that Europe’s biggest economy, Germany will suffer recession in the northern hemisphere winter. In the UK, the Bank of England will need to lift the pace and size of rate hikes after the UK Government’s announcements of funding energy price caps and large tax cuts. The latest rate hike from the Bank of England was 50bps to 1.75%. With UK inflation still running close to 10% and the Government hitting the fiscal accelerator hard, the Bank of England faces one of the most difficult challenges to bring inflation under control.
In Australia, Q2 GDP showed strong real growth, +0.9% q-o-q, +3.6% y-o-y, with the biggest contribution in the quarter (+1.1 percentage points) coming from household consumption, up 2.2% q-o-q. July retail sales, up 1.3% m-o-m, indicate that households are still spending strongly early in Q3. Essentially households are enjoying strong aggregate wage growth (Q2 GDP income data show compensation of employees up 2.4% q-o-q, 7.0% y-o-y) and are able to continue to dig in to savings accumulated during the pandemic.
Of course, not all household spending is strong. The weight of higher home loan interest rates is showing in declines in all aspects of housing activity. In July, the value of home loan commitments fell 8.5% m-o-m, the greatest monthly fall in twenty years. House prices are falling and are expected to continue to fall over the next year or so. Eventually, the weakness in housing will lead to softer household spending in general, but the process of moderating household spending is being stretched by tight labour market conditions. Employment growth is still strong, up 33,500 in August and the unemployment rate at 3.5% is still close to a 48-year low.
Because inflation is tracking well above the RBA’s 2-3% target band (6.1% y-o-y in Q2 and destined to peak late this year around 7.8% according to official forecasts) the RBA still has work to do to ensure inflation moderates to its 2-3% band over the next two years or so. However, the RBA’s inflation-fighting work does not appear as onerous as that of the US Fed dealing with inflationary wage growth and accelerating service prices, or the European Central Bank with 37% y-o-y producer prices in the inflation pipeline, or the Bank of England dealing with inflation hovering near 10% y-o-y and a government unhelpfully spending up big and priming demand.
With the Australian cash rate at 2.35%, the RBA at future policy meetings can toy with the choice of whether it should hike 50bps or 25bps, whereas the choice in the US and Europe is 50bps, 75bps or even 100bps. The RBA can reasonably look to cap out the cash rate around 3.50% early next year whereas the US and Europe have to push up above 4.00% or even 5.00%. Australia’s cash rate next year will be high enough to take the economy close to recession, but official rate prospects for the US and Europe make recession for them almost inevitable.