WEEKLY E-MAIL

24 April 2023

CENTRAL BANKS HAVE MORE WORK TO DO

By James Malliaros

One year on from the beginning of the rising interest rate cycle, Central Banks in the big three western economies of the USA, UK and European Union are still grappling with the uncertainties of ongoing inflationary pressures.

Despite recent banking stress and last year’s rapid rise in interest rates, economic momentum across the European and US economies remains resilient. Although indicators of labour market demand and headline inflation have rolled over and are expected to further moderate this year, aggregate demand and underlying inflation developments, including wage growth, are not yet compatible with a sustainable return to target inflation.

It is therefore most likely that the US Federal Reserve (Fed), European Central Bank (ECB) and the Bank of England (BoE) will need to continue raising interest rates by about 0.25% – 0.50% for the remainder of this quarter. It is then expected that rates will remain at peak levels during the second half of this year to squeeze demand and inflation.

Wage growth is a particular concern for the inflation outlook in Europe and the US. The latest US wages growth data rose to 6.4% y/y in March from 6.0% a year earlier. In the UK, underlying average weekly earnings was 6.6% y/y in February versus 4.0% a year earlier. Both measures are three-month averages, which can be slow to turn. In the Euro Area (EA), wage costs are catching up with inflation, rising 5.7% y/y versus 2.5% a year earlier.

Also, unemployment rates are either at multi-decade or historic lows; the US at 3.5%, UK at 3.8% and the EA at a record low 6.6%.

Unemployment rates at record lows

These wage and unemployment figures are not compatible with a return to target inflation levels anytime soon and therefore Central Banks would be gambling on inflation by cutting interest rates amid such current low unemployment rates and high wages growth.

Of greater concern are cyclical measures of inflation. These measures strip out certain price rises and attempt to capture inflation that is closely associated with the both the business and economic cycles.

US cyclical inflation is still too high

This shows that Central Banks still have much work to do in curbing demand and need to balance further tightening with the lagged effects of tightening that have yet to filter through. It also shows, most importantly, that an early cut in interest rates is unlikely in the short term.

Although the recent banking crisis will have some impact on bank lending behaviours, the consensus forecast is for one of a bumpy rather than hard landing for economic activity in the US and moderate growth in the EA and UK. However, economic and inflation momentum probably warrant additional but modest interest rate rises this quarter.

The forecast for Australia is for a gradual moderation in domestic inflation over the medium term to the upper range of the Reserve Bank’s (RBA) target (2% – 3%), driven by ongoing supply-side improvements against an expected pick-up in nominal wages. The cash rate will therefore most likely remain in restrictive territory and on hold at 3.60% for some time. This should allow companies and consumers to readjust to a more stabilised policy environment and for the RBA to continue monitoring the global economy, household spending and wage and price-setting behaviour.

James Malliaros
Senior Financial Planner
Certified Financial Planner®
SMSF Specialist Advisor™
Authorised Representative No. 291633

If you have any questions or comments, please email me at james@gfmwealth.com.au

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