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Cliff Notes: The trade-off between inflation and growth – Stock Forex

Key insights from the week that has been.

Monetary policy was once again the focus of concern in Australia and the United States this week. RBA Governor Lowe spoke earlier this week, providing insight into inflation dynamics and the monetary policy response. During his speech, Governor Lowe emphasized that “rising inflation is a global story,” but also that domestic conditions are contributing to it and need to be watched closely.

For the outlook, the most important domestic factor is arguably the historic strength of the Australian labor market which, if inflation expectations are no longer anchored, could lead to outsized wage demands and continued support for price inflation. to consumption. At present, longer-term inflation expectations remain consistent with inflation returning to the RBA’s target range; however, short-term expectations as measured by the Melbourne Institute have recently jumped.

Limited spare capacity, risks to inflation expectations and the policy’s “highly stimulative” starting point justified the RBA Board’s decision in June to raise the cash rate by 50 basis points. base in the minutes of the meeting. Although the policy outlook remains data driven, it is clear that the Council believes it still has a lot of work to do. In short: at 0.85%, the cash rate currently remains significantly below our estimate of neutral (1.5%-2.0%) and the RBA’s medium-term neutral expectation (2.5% ); Moreover, annual CPI inflation is not expected to peak before the end of 2022, while an easing of capacity constraints in the labor market could take years to fully materialize given the uncertainties associated with the migration.

After this week’s developments, we added another 25 basis points of rate hikes to our futures profile. As detailed by Chief Economist Bill Evans, two more rate hikes of 50 basis points are now scheduled for July (unchanged) and August (previously +25 basis points) to bring the cash rate back to the midpoint of our neutral range (1.85%); after a two-month pause, 25 basis point hikes at the November 2022, December 2022 and February 2023 meetings should leave the cash rate broadly in line with the RBA’s medium-term neutral level. This peak is well below market expectations, but a position that we believe (over time) will allow inflation to return to target without undue cost to the real economy.

On the data front, the Australian Chamber Westpac Business survey for the June quarter showed that Australia’s manufacturing sector was in great shape. The rebound in activity after the reopening saw production and new orders increase at a faster pace in the second quarter, and expectations for further growth in the September quarter remain positive. Manufacturers responded to this by increasing their workforce and increasing overtime. That said, the upside in growth is capped by significant and persistent headwinds. Labor and material shortages have been noted as the most limiting factors to production and are at their most extreme levels since the oil shock of the mid-1970s. Costs are rising rapidly, compressing profit margins and exerting upward pressure on the prices of finished products and therefore on consumer inflation.

Overseas, data flow was also light this week, leading to particular attention to FOMC Chairman Powell’s testimony in Congress. His comments confirmed significant further tightening in the coming months, in line with our forecasts. However, Chairman Powell’s thoughtful commentary also pointed out that the FOMC still believes it is possible to eliminate current inflation risks without causing a recession (and wishes to do so), that it is vigilant about the risks to on the business and will adjust the policy stance to balance these risks if necessary.

We are more concerned about the underlying strength of US economic activity and therefore expect a lower and earlier Federal Funds rate than the market and FOMC (3.375% in December 2022 vs. around 3.8% in 2023) . We also expect a more aggressive and earlier rate cut cycle of 125 basis points from the end of 2023.

Finally, as the market becomes increasingly obsessed with the likelihood and timing of a US recession, the biggest concern for us is the cumulative loss of growth relative to medium-term potential. Despite strong domestic demand in the first quarter, GDP contracted due to strong imports and low inventories in the three months to March. Today, in the second quarter, domestic demand has slowed such that the Atlanta Fed’s nowcast for quarterly GDP growth points to a flat outcome. Moreover, leading indicators point to below-trend growth in the second half of 2022; and, with falling real incomes, tightening financial conditions and a potential negative wealth effect ahead, there is little reason to suspect that US growth will pick up significantly through 2023 until support lower interest rates are felt. While the opening of a large output gap is useful for containing inflation, it is clear that it also jeopardizes long-term productivity and wealth.

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