Last week, we raised our forecast for the US federal funds terminal rate in December from 2.675% to 3.375%.
We now expect this more aggressive approach to see the US economy stagnate, with the risk of a mild recession in the second half of 2023. % through 2024.
This cycle for the rest of 2022 will lead to increases of 75 basis points in July; 50 basis points in September; 25bps in November and 25bps in December.
This move towards higher global rates also led us to raise our terminal rate for the RBA tightening cycle from 2.35% to 2.6%. Note that this remains well below the market-expected terminal rate of around 4.5% and only a 25 basis point upward revision from the 75 basis point rise in the fed funds profile.
The 2.6% rate is broadly in line with the “2.5% guideline” the RBA Governor has given in his speeches and other comments (from his interview with ABC on June 14: “I think ‘it is reasonable for the cash rate to hit 2.5% at some point.’).
The sensitivity of the Australian economy to the RBA cash rate is significantly higher than the sensitivity of the US economy to the federal funds rate. Around 60% of Australian mortgages are variable rate, with the remaining 75% of fixed rate loans expected to mature by the end of 2023.
Indeed, 90% of mortgage borrowers are directly exposed to movements in the RBA cash rate over the next year and a half. The rate affects borrowers and homeowners through several channels, including: cash flows from existing borrowers; the ability of potential borrowers to obtain and service new loans; the wealth effect of associated house price adjustments; and through trust effects.
In the United States, the current surge in mortgage rates only directly affects new borrowers, as existing borrowers typically have fixed rate mortgages of up to 30 years.
The most direct impact of the federal funds rate on financial assets in the United States is through the stock market and confidence. This 25 basis point upward revision to the forecast terminal rate will likely result in a 50 basis point increase in the cash rate at the August board meeting – revised upward from our previous forecast of 25 basis points.
This would take the cash rate from our forecast of 1.35% (after the expected 50 basis point hike at the next July meeting) to 1.85% after the August meeting – firmly in our “zone”. neutral” estimated for politics in Australia at 1.5-2.0%.
The August board meeting will respond to what is expected to be a very troubling inflation report for the June quarter, due out July 27.
We expect headline inflation to increase by 1.5% in the quarter, pushing annual inflation up from 5.1% to 5.8% annually. Core inflation, represented by the trimmed average, should stand at 1.2% during the quarter for an increase in annual inflation of 3.7% to 4.5% per year.
We see the risks to these numbers on the upside.
Having reacted strongly to the new significant rise in inflation – moving the cash rate into the “neutral zone” and signaling a clear commitment to containing inflation and inflationary expectations – we expect the RBA to make a pause.
Consistent with our previous view, we expect a two-month pause to assess the impact of the rapid 175bps four-month cumulative rise.
As the governor noted in this week’s address to the U.S. Chamber of Commerce, the key high-frequency data he will be watching will be consumer spending, particularly consumer durables and the housing market – and not just house prices (as an indicator of wealth effects) but also with respect to house building and other housing-related expenditures.
It should be noted that a quick move to 1.85% will only restore the cash rate to slightly above the 1.5% rate that held for almost three years between August 2016 and May 2019, when inflation has consistently been below the Bank’s 2-3% target zone.
Acting quickly to reverse what is clearly an overstimulating policy framework, then pausing before entering the “contraction zone” is the best approach, and the one most likely to avoid the damaging overshoot we anticipate. for the FOMC.
Such a strategy would also contribute to the central objective of the tightening cycle: to send a clear signal to economic agents – households and trade unions in particular – that the Bank is committed to bringing inflation back to its medium-term target, thereby containing any rise in inflation. expectations.
In his speech, the Governor made a major point around the key objective of containing inflationary expectations.
Our central argument remains that, following the publication of the September quarter inflation report on October 26, further tightening will be considered necessary at the November board meeting.
In this report, we expect annual headline inflation to be stable at 5.7% per year (partly due to state government subsidies that temporarily prevent the effect of a sharp increase in the cost of electricity), but that underlying inflation rose from 4.5% per year to 4.8% per year. .
The next step would place the policy in the contraction zone. As such, it would be prudent to return to a procedure in 25 basis point increments given the added uncertainty surrounding the impact of each move.
We continue to expect further movement in December and a final 25 basis point increase at the February board meeting in response to the December quarter inflation report.
The December quarter should see the peak of headline and underlying inflation. (respectively 6.6% and 4.8%). After reacting to this decision, it would be prudent to put on hold to assess the economy’s response to a cumulative increase in the cash rate over nine meetings of 250 basis points.
Such a move would mark the second-fastest round of tightening since 1990, surpassed only by the 275 basis point hike over five meetings in the second half of 1994.
We expect that alongside the sharp slowdown in the economy in the December and March quarters in particular, the March quarter inflation report will provide evidence that the slowdown in demand and the release of supply brought together demand and supply. inflationary pressures.
In the March Inflation Report, we expect annual headline inflation to have fallen from 6.6% to 5.6% pa and core inflation to have fallen from 4.8% at 4.2% per year.
This evidence would be available by the May 2023 Board meeting, allowing the Board to move to a “wait and see” approach, potentially signaling the end of the tightening cycle with the cash rate having reached 2.6. %.
We also expect evidence of the sharp slowdown in the US economy to signal to the board that stable policy is appropriate.
The markets have no sympathy for our view that the RBA can chart this course. They would point to the unsustainability of the Australian cash rate which stands at 87.5 basis points below the fed funds rate.
Australia’s soft landing will allow the RBA to hold rates steady in 2023 and 2024 as inflation gradually returns to the 2-3% target zone.
According to our forecast, after the FOMC is forced to reset its policy following the blocking of its economy and its potential slide into recession, the RBA’s cash rate would settle at around 50 basis points above above the federal funds rate by the second half of 2024.
We accept that our forecast for the cash rate assumes successful navigation of a very narrow path to a soft landing.
In particular, the risks we have seen recently with large wage settlement increases are troubling. This is why it is so important for the RBA to be decisive in the early stages of the tightening cycle with a clear message that it is committed to containing inflation risks.
A quick move into the neutral zone is a critical step and we strongly support embracing these three back-to-back 50bps moves before a break in September.