How high will rates go? Latest US inflation data doesn’t clear the air

Every US inflation report is taking on greater significance for financial markets and the economies of America and the rest of the world as the Federal Reserve’s interest rates edge closer to their peak. Yet where and when that peak might lie wasn’t made any clearer by the latest data release.

The headline rate of US inflation in January was 6.4 per cent, a marginal decline from the 6.5 per cent rate a year earlier and a similar fall from the December rate. “Core” inflation – excluding food and energy prices – also fell from 5.7 per cent to 5.6 per cent year-on-year, and from 5.7 per cent to 5.6 per cent from December to January.

Jerome Powell, chairman of the US Federal Reserve, has warned that the process of lowering US inflation would probably be bumpy rather than smooth and would take “a lot of time.”Credit:Bloomberg

That was slightly less of an improvement than economists had expected, but at least continued the improving trend of recent months.

While there was a mixed reaction from financial markets – the sharemarket essentially flat-lined, but bond yields crept up – the general consensus was that the numbers were consistent with the recently-expressed view of Fed chairman Jerome Powell that the process of lowering US inflation would probably be bumpy rather than smooth and would take “a lot of time.”

The data did nothing to undermine the view, also expressed by Powell, that the process of disinflation is continuing – but it suggests that it will take longer than many in markets were factoring in at the start of this year and involve a higher peak, or “terminal,” federal funds rate than they expected.

The bond market is now pricing in at least two more 25 basis point increases from the Fed’s March and May meetings, which would take the upper end of the Fed’s targeted range for the federal funds rate (equivalent to the Reserve Bank’s cash rate) from its current level of 4.75 per cent to at least 5.25 per cent.

US rates matter, and not just for the US.

There was some recent controversy (amid a range of controversies that surround him) over the RBA governor Philip Lowe’s private lunch with investment bank Barrenjoey.

Lowe was reported to have said there was a possibility that Australia’s rates (currently 140 basis points lower than the federal funds rate) could go as high as America’s in this cycle. A spokeswoman, however, has denied that. What he actually said, apparently, was that one of the issues he’s working through is the differences in interest rates across countries.

The most important of those differences for the RBA is that between the federal funds rate and its own cash rate because, if it widens too much, the US dollar’s value will blow out against the Australian dollar, triggering capital outflows and a depreciation of our currency that would essentially import inflation (because imports would become more expensive in Australian dollar terms) into an economy already struggling to lower its inflation rate.

Rates dilemma

If interest rates in the two economies get too far out of line, the RBA would be under pressure to raise Australia’s interest rates further, and probably for longer, than it would otherwise choose to do.

Other economies would confront the same dilemma, which is why the Fed is the most influential of the central banks and why the US inflation rate and the Fed’s responses to it are among the most consequential pieces of data for the global economy.

The fact that the US inflation rate continues to slide is encouraging, but the slowing of the pace of the decline is not. It fits with the “higher for longer” scenario of the more pessimistic analysts.

The “glass half full” pundits, however, see glimmers of more encouraging trends within the headline numbers and other recent US economic data.

Wage pressures in the US economy, which had been rising, are now easing despite record low unemployment. Corporate profit margins have begun to shrink. The pandemic-inflicted supply chain bottlenecks that were a major driver of the initial breakout of inflation around the world have largely been resolved. Financial markets are still pricing in the start of a fall in rates by the end of this year.

The biggest driver of the inflation rate is what the Americans describe as “shelter” costs, or housing-related costs such as mortgage payments and rents. They were up 0.7 per cent month-on-month.

There is, however, a lag before recent changes in prices feed into the inflation data and the recent trend in lease renewals has been for reduced rents. That trend should surface in the inflation data in the second half of this year.

Oil prices for both US West Texas and the internationally-traded Brent crude were rising in January and flowing through to US petrol prices.

They’ve since fallen, have yet to be impacted (if they are impacted) by Russia’s announcement that it will reduce its production by 500,000 barrels a day and have yet to benefit from Joe Biden’s announcement this week that he will release another 26 million barrels from America’s strategic oil reserves.

The data does support the disinflation thesis, although it doesn’t argue against further rate rises or holding rates at elevated levels until the inflation rate is pushed down to the Fed’s 2 per cent target, probably by rising unemployment.

Delicate point in rate cycle

The lead time, or lags, before the effect of rate decisions actually show up in economic data means that the Fed and central banks elsewhere are reaching the delicate point where a misjudgement will have real economic consequences.

If they don’t raise their rates enough, and hold them there for long enough, inflation will be entrenched at unacceptable levels, and they will have to re-start the process from a much higher interest rate base, inevitably forcing their economies into recession.

If they are able to finesse this late stage of the rate-hiking cycle, however, they’ll achieve the much-sought-after “soft landing” where they’ve choked off inflation without killing their economies and destroying people’s lives in the process.

Fed vice chair Lael Brainard’s departure to the White House could lead to more conservative rate decisions.Credit:Bloomberg

Whether it’s the Fed or the RBA, it is people who make these decisions and so the announcement that the Fed’s vice chair Lael Brainard has been recruited to the White House as the new head of Joe Biden’s National Economic Council is probably not good news for the more optimistic.

Brainard is a noted and very influential “dove.” While she was supportive of last year’s aggressive rate hikes, she has more recently been stressing the risks of tightening monetary policy too far.

Depending on who Biden nominates to replace her and how long it takes to seat them on the Fed board, her departure will alter the balance between the doves and the hawks within the US central bank and could lead to more conservative outcomes than might otherwise have been the case.

That prospect would be a little disconcerting for those optimistic about the likelihood that the US rate cycle will peak mid-year and then begin to taper towards the end of the year – as well as for central bankers in other jurisdictions, like Australia, who have enough on their plate without having to respond to the possibility of a “higher-for-longer” cycle in the US.

The Business Briefing newsletter delivers major stories, exclusive coverage and expert opinion. Sign up to get it every weekday morning.

Most Viewed in Business

From our partners

Source: Read Full Article