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Turning Doves to Hawks

Financial markets took in their stride the news on Friday that US annual CPI inflation had climbed to a near 40-year high 6.8% y-o-y in November. The richly valued S&P 500 rallied to a new record high, while the US bond market was unperturbed. The prevailing view in financial markets is that the high November CPI reading was no higher than expected by the markets and will not drive the Federal Reserve to accelerate reduction of its bond buying at its policy meeting this week. The markets are 100% convinced there will be no increase in the Fed’s emergency low 0-0.25% Federal Funds rate.

Based on what various senior Fed officials have been saying recently, including recently re-appointed Chairman Jerome Powell, the markets are probably right in their assumption that the Fed will stay dovish in the near-term. While throughout 2021 the Fed has serially under-forecast the rise in US inflation and admits that the rise in inflation can no longer be considered transitory, the Fed is giving no signals that it is about to start fighting the rise in inflation.

Instead, the Fed is slowly reducing its super-stimulatory bond buying program and leaving in place a Federal Funds rate that on historic real basis has moved from –6.1% based on the October CPI to –6.7% on the November CPI. The dial on US monetary policy is set firmly on priming stronger demand and higher inflation. US budgetary policy remains highly expansionary too with massive multi-year spending totaling near $US4 trillion on hard and social infrastructure in the wings.

Meanwhile, high US demand supported by rising employment, wages and household wealth as well as highly supportive monetary and fiscal policy settings is still running up against constrained supply. While high annual US inflation may step down on some pull-back in month-to-month CPI readings over the next few months, everything else, especially policy settings, are pointing to higher annual US inflation longer-term.

At some point, the Fed will have little option but to tackle inflation that has risen too high. Whether it is 7, 8, or 9 handle on the annual inflation rate that turns the Fed from dove to hawk is hard to say. What is clear is that more alarming US annual inflation rates are becoming more likely at some point in 2022 and it is reasonable to expect that the Fed will be forced from delaying rate hikes to trying to catch up and starting early in 2022.

In Australia, inflation pressure is building at lesser pace than in the US. Annual CPI inflation is at the top of the RBA’s target range at 3.0% y-o-y in Q3 2021. It is likely to lift above 3.0% in Q4 and stay well above 3% in Q1 2022. Even if there is a brief base-effect dip in annual inflation beyond Q1, current economic policy settings - a cash rate at 0.10% (-2.9% in real terms) plus plenty of government spending in a pre-election March budget – all but guarantee a renewed push higher in annual inflation in late 2022. Expansionary policy settings adding fuel to the strong rebound in household and business spending post-lockdowns will generate strong demand-pull inflation pressure late-2022 moving into 2023 that could see annual CPI inflation with a 4 handle and possibly even higher.

Annual CPI inflation undulating through high 2% mid-2022 to low 4% early-2023 will test the patience of the RBA. It will challenge its view that there is no permanently higher inflation until wages rise above 3% y-o-y. Instead, it is likely to become clearer that demand-pull inflation will eventually generate the higher wages growth that reinforces the rise inflation unless there is a policy change circuit-breaker.

At some point in 2022 we see the RBA changing from dove to hawk on inflation. The conversion will be later than the US Fed’s conversion prompted by 1980s-style US inflation readings forcing it to start hiking rates probably in Q1 2022. The RBA may be able to hold out until the second half of 2022 before starting to hike rates.

The Fed and the RBA have spent 2021 furiously stoking demand and inflation. Their in-house economic forecasts throughout the year have fallen short of predicting the demand and inflation generated. It has almost been a surprise to them what they have helped to unleash. Now they have mounting evidence that ultra-easy monetary policy left in place too long during economic recovery and one beset by supply challenges will generate high inflation.

Central bank policy credibility is increasingly at stake if their inflation forecasts keep under-shooting during 2022. The risk of losing credibility makes the remaining central bank doves from 2021 an endangered species in 2022.

As the doves turn to hawks, we expect the US Fed to hike rates three times in 2022 taking the funds rate to 1.00% by year-end. We expect the RBA to hike rates twice in 2022. The first hike is likely to be small, probably 0.15bps taking the cash rate to 0.25% in July or August. We pencil in a second 25bps hike to 0.50% in Q4 2022.