Roger J. Kerr says the RBA needs to rethink its approach to taming inflation, US economic grows slows, and the Japanese have been restrained so far on intervention on behalf of the yen

Summary of key points: -

• Reserve Bank of Australia in need of a rethink
• US economic growth slows up
• The Japanese hold back on threatened FX market intervention

Australian inflation data for the March quarter released last week has caused a complete backflip by their interest rate markets. Inflation for the quarter increased by 1.00%, significantly enough above prior forecasts of a 0.80% increase to cause a massive market turnaround from rate cuts to rate hikes. The interest rate markets instantaneously pivoted from pricing in a 70% probability of an interest rate cut in August to a 50% chance of a 0.25% rate hike. If an interest rate hike does eventuate it would put Australia completely at odds with all other central banks (e.g. the Fed and ECB) who are poised to cut interest rates over coming months.  

How did the interest rate market and the Reserve Bank of Australia (“RBA”) get this so wrong?

Why the RBA finds itself in this predicament of high inflation so late in the economic cycle goes back to their far too timid response to tightening monetary policy when rising inflation emerged some 15 months ago. In their wisdom, the RBA believed that interest rates as high as 4.35% would be sufficient to slow the demand in their economy and bring inflation back down. They were always out of step with the RBNZ and Fed who hiked interest rates to 5.50%. The Aussie dollar has suffered weakness for all this period as Australian interest rates have been so far below those of the US, currency speculators effectively being paid to sell the AUD against the USD.

The RBA’s over-confidence, perhaps complacency and almost arrogance at somehow being different to all others in controlling inflation has turned around to bite them in the bum!

Australian inflation has increased again as higher wage increases are being passed on into increased selling prices, particularly in the services sector. As we have highlighted in this column over several months now, in addition to the wage increases, rents, house construction costs, electricity prices and transport costs are not declining, and all these categories increased in the March quarter.

In being so slow to increase interest rates in early 2023 and then to stop at 4.35%, the RBA have created the problem for themselves. More experienced central bankers know that when the inflation genie is out of the bottle, you must move swiftly and severely in a “shock treatment” of sharply tighter monetary policy to change price setting behaviour in the economy. The RBA failed to do that and are now paying the price for those poor decisions.

Several leading economists in Australia have also completed some handstands on their forecast for interest rates and are now predicting three more rate increases this year to 5.10%. The RBA have always kept their options open about the need for further interest rate increases, or alternatively decreases. In its March monetary policy decision, the RBA concluded that it remained “resolute in its determination to return inflation to target” and said it was “not ruling anything in or out”. We would have to expect that there would be much more definitive wording in their next statement on 7 May as their strategy to date has not worked to reduce inflation.

Adding to the uncomfortable situation is the Australian Federal Government is about to deliver a budget statement that will include income tax cuts, which in theory is a stimulus to household spending. Many would argue that Treasurer, Jim Chalmers should be taking money out of the economy in a contractionary budget, not pumping more money in.

Upcoming Australian economic data will determine whether the RBA increase interest rates at their 18 June meeting or 7 August meeting, either way it stands out as very positive for the Australian dollar value.

Last week Australian wholesale prices (Producer’s Price Index) increased 0.90% in the March quarter, lifting the annual increase to 4.30%, substantially above prior forecasts. Wages data on 15 May and employment numbers on 16 May will be important signposts for what will be a potentially embarrassing pivot by the RBA to further rate hikes.

Australian two-year Government bond yields have increased 50-basis points to 4.20% from 3.70% at the start of April. Typically, such a rapid increase would send the AUD soaring higher against the USD. However, the AUD at 0.6535 to the USD is at the same level it was at the start of the month. Holding the AUD back has been a similar 40-basis point increase in US two-year Treasury Bond yields from 4.60% to 5.00% over the same period. The interest rate gap between the two currencies has only marginally closed.

Looking ahead, it requires weaker US economic data to prove to the markets that the Fed will still be cutting interest rates this year. On the assumption that this occurs, the US two-year yields will reverse back towards 4.00% and the interest rate differential will finally move back in favour of the AUD. Given the high level of speculative AUD “short-sold” positions currently in place, the closure of the interest rate gap will force a large amount of AUD buying as those currency punters unwind their positions. A return of the AUD/USD exchange rate to above 0.7000 is very much on the cards if the RBA re-tighten policy and the key chart resistance level just under 0.6600 is broken to the upside (refer chart below).

US economic growth slows up

Over recent weeks many US-based economic commentators have proffered the view that interest rate cuts should not be made this year as the US economy is still expanding strongly and that proves that the economy has not been hindered by higher interest rates. That viewpoint took a major blow last week with US GDP growth in the March quarter reducing sharply to 1.60% (annualised) from 3.40% in the December quarter. Consensus forecasts were for a 2.50% increase in the March quarter, so significantly weaker than expected.

Other economic measures have also indicated a slowing in business investment and spending in the US economy.

The argument that the US dollar must remain strong as the US economy is outperforming all others took a hit as well. There was no great reaction by interest rate and FX markets to the March PCE inflation figures released on Friday 26 April as the increase in inflation for the month was precisely on forecast at +0.30%. The argument for why US interest rate cuts should be delayed this year is because inflation has stalled at around 3.00% and will not reduce any further. Our previous analysis has shown that US inflation is always higher in the first three months of the year and this year was no different. The inflation readings for April and May stand to be significantly lower and therefore forward interest rate pricing can easily move in the other direction (i.e. downwards) before the Fed’s June meeting.

The US dollar Dixy Index appears to have peaked out again at 106.20 about 10 days ago, however it requires continued softer than expected economic data to turn US interest rates and the USD down again.

US economic data to watch for this week includes the ISM Manufacturing PMI survey (which should fall below 50) on Thursday 2 May and the ISM Services survey and Non-Farm Payrolls jobs numbers on Friday 3 May. An employment increase in April well below consensus forecasts of 190,000 new jobs could well be the first of series of US economic data that starts to evidence a stalling economy, as well as the stalling inflation decreases over recent months.

The Japanese hold back on threatened FX market intervention

Global foreign exchange markets continue to speculate against the Japanese Yen, selling it to fresh 34-year lows last week of 158.35. The Yen selling has continued unabated as the Bank of Japan has yet again disappointed with no change to their official interest rates last week after the miniscule increase in March. The Bank of Japan has increased their inflation forecast (which would normally suggest further monetary tightening), however decreased their GDP growth forecast for this year (perhaps preventing them from hiking interest rates again). It does seem inevitable that they will have to increase their interest rates again and/or intervene directly in the FX markets buying the Yen, as they have been threatening to do.

The cat and mouse game with the FX markets over the intervention threat has so far not worked with the markets selling the Yen until they see proof of intervention, and then the speculators will aggressively buy the Yen to unwind their short-sold positions built up over recent months.

Japan’s increasing inflation rate will only get worse unless they stop the depreciation of the currency, as Japan imports all its oil and a considerable amount of its food. When the inevitable intervention arrives the movement in the USD/JPY exchange rate could be spectacular. The buying of the Yen and selling of the USD (when it occurs) will be a positive for the NZD and AUD.

*Roger J Kerr is Executive Chairman of Barrington Treasury Services NZ Limited. He has written commentaries on the NZ dollar since 1981.