Inflation running much higher than central banks expected previously is causing them to rethink the appropriate monetary policy response to tame inflation. Most, including the RBA, are admitting that demand growth is running faster than growth in supply of goods and services and with little chance of materially lifting supply near-term because of continuing supply chain problems made worse by the Ukraine War and China’s Omicron lockdowns, slowing growth in demand towards growth in supply is the only way to cap inflation and bring it back down close to inflation targets. Using blunt-edged monetary policy to batten down demand growth is high risk and could easily go too far. Recession risk is rising.
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Financial markets remained volatile in May torn between evidence of strong economic activity and concern that central bank interest rate hikes will dampen future activity and possibly lead to recession. Inflation and its many underpinnings are driving the likely course of central bank rate hikes. Views about central bank rate hikes are varied, adding to market volatility.
Global economic growth is losing pace weighed by lessening monetary and government budgetary policy support as well as rising cost of living pressures. Downside risks to economic growth abound from rising interest rates, disruption to food and energy supplies as the war in Ukraine continues and China’s reliance on lockdowns to contain Covid outbreaks. Yet the underpinnings for economic growth remain firm from low unemployment rates in many major economies as well as the past build-up of household savings. If global recession lies ahead, it is not on the cards for another year at least.
A change of Government, even one born out of the upheaval of a marked shift in voting allegiance towards minor parties and independents, will make minimal difference to Australia’s economic outlook in the near-term. The new Government is in with a majority in the lower house it seems. It promised nothing before the election that will alter Australian economic prospects materially in the near-term.
The RBA is in an enviable position compared with its peers in North America, the United Kingdom and New Zealand. Australian inflation is high by our standards but comparatively low by international standards. At this stage, Australian inflation also seems less likely to become entrenched compared with inflation elsewhere. The US Fed, Bank of Canada, Bank of England and Reserve Bank of New Zealand are belatedly chasing down high inflation rates running at multiples of their respective inflation targets jumping. All have had to hike several times with the occasional 50bps rate hike thrown into the policy tightening mix.
Volatile financial markets in April saw risk assets mostly weaken during the month and government bond yields pushed higher. High inflation readings prompted some central banks to deliver bigger interest rate hikes and the US Fed indicated that when it meets this week it may deliver a 50bps rate hike. Rising interest rates were one factor in April adding to the risk of slowing global economic growth. Other factors were the impact of the Ukraine conflict and China’s difficulty containing Omicron. Despite the increasingly gloomy global economic growth outlook, recent economic data in the US remains strong and the likelihood that annual US inflation readings peaked in March/April and will reduce for a period. This may provide the Fed with leeway to hike interest rates at a slower pace than financial markets are expecting over the next year.
Australia’s annual CPI inflation rate is likely to peak for the current upswing with the Q1 2022 CPI report to be released on Wednesday 27th April. Annual headline CPI inflation will be around 4.5% y-o-y, comparatively low by international comparison, but well above the RBA’s 2-3% target range. Underlying annual inflation using the trimmed mean and weighted median measures are likely to push up to around 3.2% y-o-y in the Q1 report but may not peak until the Q2 or Q3 2022 reports.
Swings in economic activity over the past two years have been unusually large with most advanced economies experiencing deep recession in mid-2020 and strong growth, albeit bumpy at times, since. The global pandemic and restrictions to contain it were responsible for the deep recession and the bumpiness of the recovery since. The power behind the post-recession recovery came from a large-scale lift in government spending combined with central banks ramping up their balance sheets with bond purchases and keeping interest rates exceptionally low.
In March high inflation and what central banks might do to tackle it was the dominant theme in financial markets. Government bond markets suffered their worst month in 30 years with yields up sharply responding to fear of aggressive hikes in official interest rates by central banks. The US Federal Reserve (Fed) facing sustained high US inflation caused by strong growth stretching disrupted supply chains and showing signs of being sustained by rising wages, talked about the need for regular and bigger rate hikes. It delivered at its March policy meeting a minimal 25 basis point (bps) rate hike taking the Federal Funds up to 0.25% to 0.50% range to combat US inflation at 7.9% y-o-y in February and expected to be above 8% in March.