Mission accomplished? Fed’s inflation success raises hopes for RBA

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It may not be quite “mission accomplished,” but the latest inflation data in the US suggests that after the fastest tightening of monetary policy in 40 years, the Federal Reserve has finally brought inflation under control.

The better-than-expected US inflation numbers fit within a global picture of steadily ebbing inflation rates as the lagged effects of rate rises in developed economies over the past year and a half are now flowing through to the official data.

Fed chair Jerome Powell: The US central bank has managed to put a lid on America’s inflation rate.Credit: Bloomberg

The way financial markets responded to the release of the data – the US sharemarket rose nearly 2 per cent, with tech stocks doing even better, bond yields tumbled about 20 basis points and the US dollar was sold off – signals that investors believe the Fed’s work is done and that there will be rate cuts, not more increases, next year.

Headline US inflation flat lined relative to September’s figure and was 3.2 per cent year-on-year. Core inflation (excluding energy and food costs) was 0.2 per cent month-on-month and 4 per cent year-on-year. If housing costs were also excluded, “supercore” inflation was 0.2 per cent month-on-month and 3.75 per cent year-on-year.

Those numbers suggest that, after peaking at 9.1 per cent in June last year, the US inflation rate is tracking nicely towards the Fed’s goal of 2 per cent.

Moreover, it’s doing so without any meaningful pickup in unemployment or damage to the economy, which grew at 4.9 per cent in the September quarter. The prospect of the Fed pulling off the central bankers’ holy grail of a “soft landing” remains alive.

The apparent success of the US central bank’s policies augurs well for central banks elsewhere, including the Reserve Bank, as they have been tracking the Fed’s path, albeit generally not as aggressively.

The Fed has raised US rates 11 times in a cycle that started in March last year, with its federal funds rate rising from 0.1 per cent to a range of 5.25 per cent to 5.5 per cent.

The RBA has raised the cash rate 13 times, starting in May last year, to its current level of 4.35 per cent.

Inflation in Australia peaked at 7.8 per cent in December last year and was running at 5.4 per cent (year-on-year) in the September quarter – it’s trending in the right direction, but is perhaps six months behind where the US, which began its rate-hiking more aggressively than the RBA, is today.

What the US experience indicates is that the cumulative effect of all the Fed’s rate rises is biting.

A similar impact could be expected here, with the instant 1.5 per cent depreciation of the US dollar against the trade-weighted basket of other major currencies – and a 1 cent rise in the Australian dollar – helping the RBA’s cause by making imports a little more expensive if it’s sustained.

It’s not just the tighter monetary policies – with their impact exacerbated by an even stronger rise in yields in bond markets in the past couple of months – that are slowing inflation rates.

The surge in inflation last year has been attributed to the shocks to supply chains generated by the pandemic.

The apparent success of the US central bank’s policies augurs well for central banks elsewhere, including the Reserve Bank.

That has been overlaid by the shifts in trade flows as companies (with urging from some governments) restructured their supply chains to make them less vulnerable and in response to the heightened tensions between the US and China, whose vast and low-cost manufacturing sector had previously anchored most global supply chains.

The massive fiscal response by governments to the pandemic, which left consumers flush with cash, also played its part in the inflation break-outs.

The supply chain issues were resolved some time ago, although the higher costs of the restructured supply lines will continue to flow through.

It also seems that US consumers have exhausted the savings windfall they gained from the fiscal largesse during the pandemic. The financial pressures on households in the US, and here, has increased.

Another, perhaps increasing, downward influence on inflation rates globally could come from China.

With a faltering economy and sluggish global growth, China’s factories have excess capacity. Beijing’s attempts to stimulate have been largely centred on its manufacturing centre, raising the prospect of even more excess capacity and a flood of cheap goods into global markets, lowering prices and reducing inflation rates.

It is ironic that, having been fixated on high inflation rates for nearly two years, central bankers might be more concerned about the rates of disinflation next year.

Certainly, the response of the financial markets to the US data was to rule out any further rate rises in the US in this cycle and to bring forward expectations of rate cuts next year.

While the Fed has maintained – and markets had previously accepted – its “higher for longer” mantra and has been signalling at least one more rate rise this year and no rate cuts until towards the end of 2024 at the earliest, there is now a conviction in the markets that the Fed will be easing rates next year to achieve a soft landing for the economy.

There are some obvious caveats to the view that this relatively brief era of excessive inflation (and the spikes in interest rates in response) is passing.

The most obvious is the volatility of geopolitics. The war in Ukraine, the conflict in the Middle East, the delinking of the US and its allies from China’s economy and America’s attempt to constrain China’s technological capabilities are all threats to global stability.

The potential for steep increases in energy and/or food costs is latent in the conflicts, while the efforts by the US, Europe and others to reduce their dependence on China for some critical products and minerals may also result in increased costs.

In the US, whose economy and financial markets significantly influence other economies, there is also political instability and dysfunction and some difficult and escalating fiscal challenges that could be disruptive for the markets and economy. The risks there, however, appear mostly on the downside – they are more likely to be deflationary than inflationary.

Absent some new development, it is apparent that the trends in inflation in the US and elsewhere are now clear and positive, and that the challenge confronting central bankers next year won’t be combatting excessive inflation rates but – with the lagged effects of past rate rises and the withdrawals of central bank liquidity still flowing through– finessing their monetary policies to avoid unnecessary and avoidable economic damage.

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