Australia’s economy a hop, skip and jump from recession

As we come to the middle of the year, the economy is transitioning through a ‘hop, skip and a jump’ towards recession late this year or in early 2024.

As we come to the middle of the year, the economy is transitioning through a “hop, skip and a jump” towards recession late this year or in early 2024.

For now, the economy is “hopping” along better than many had expected at this point after such an abrupt rate hiking cycle. This resilience has markets considering if a few further rate hikes may be needed to complete the intended demand destruction required to dent demand-driven inflation.

Central bankers know they have already done a great deal in moving rates quickly to restrictive territory and, while they acknowledged inflation is yet to fully moderate (this takes time as demand cools), they are trying to buy time knowing the lag effect will complete this process, and therefore much of their own communications reference “skipping” a few meetings on the road to further rate hikes to access more incoming data.

Due to the long and variable lag effects of monetary policy, any further hikes now will continue to affect the economy well into 2024, meaning at some point the cumulative tightening will trigger the economy to “jump” into a protracted slowdown, killing inflation and allowing for a new cycle to be born as policy stimulus can again be provided away from restrictive settings.

Recently, while employment readings have softened with unemployment moving a little higher (from 3.5 per cent to 3.7 per cent) and tepid real retail sales numbers, some inflation readings have remained elevated, giving the RBA cause for concern. Combined with stubbornly resilient house prices, this may see the rates cycle elongate as our own path to terminal rates may become a little longer, with no doubt a few meetings of skipping introduced to also buy time to access the economic impact of previous hikes. In last week’s Senate testimony, governor Philip Lowe referred to rates already being “restrictive”, suggesting the RBA has made significant ground towards slaying the inflation beast: “We’ve increased interest rates a lot. Monetary policy is restrictive and it’s working.”

There is now significant divergence as we look around developed economies, with each country now embarking on its own rates journey. Last month the Reserve Bank of New Zealand completed its rate hiking cycle lifting rates to 5.5 per cent, and telegraphed to markets it expected to remain on hold at this level. This is an important cyclical marker, as the RBNZ was one the first and fastest rate hikers in this global cycle. We believe the New Zealand economy is currently in recession, with a raft of negative economic data across the board (retail sales, consumer confidence, activity outlook, and business confidence are all negative).

Similarly, the Bank of Canada has paused at 4.5 per cent, suggesting it is also in a wait and see mode after significant monetary policy tightening. Again, data in Canada has been soft with negative retail sales, payrolls and a flatlining monthly GDP number.

The US Federal Reserve has also suggested it may pause (or skip) hiking rates, as again it wishes to view more data and access the fallout from the regional banking crisis. US data has also been patchy, with weak purchasing managers index readings and weak (negative) regional confidence or outlooks from a raft of areas. But the employment market keeps on keeping on, adding solid gains in the recent May release. At a headline level the gains are welcome, but as keen US Fed watcher Nick Timiraos noted, this also has a “choose your own narrative” element to it, where one must decide whether it calls for further policy response.

The unemployment rates jumped from 3.4 per cent to 3.7 per cent, while average hourly earnings – a key metric for the US Fed in assessing wage growth – remained well contained at 0.3 per cent. This lower average hourly earnings (plus additional months revised lower) suggests that employment is growing but employers have a lot more power over containing wages. This is the dream scenario for the US Fed – job growth remains steady, but wages moderate – something it has been pushing in its recent research too.

This all suggests that there is good reason for many central banks to pause/skip at this point, if they are to achieve their dreamy “soft landing” scenario, given the highly divergent nature of some incoming economic data. Leading data continues to fall with manufacturing PMIs across the world remaining poor (most below 50, with a level of 50 considered flatlining). While manufacturing has historically dominated the business cycle, services PMIs remain healthier. Interestingly, output prices have now fully normalised and supply chains are completely back to normal of pre-pandemic levels.

There remains a raft of issues that can push the markets into “jump” territory, and most market participants believe this is the inevitable pathway through time. The exact catalysts and timing remain unknown but after such violent rate increases, to restrictive settings, the through time expectation remains a more challenging environment. It may be an acceleration of weaker economic data, a fraught geopolitical issue, or the aftermath of US debt ceiling politics. Having narrowly avoided the perils of the US debt default again, the US Treasury will now issue more than $US1 trillion worth of securities to replenish its general account buffers (these were drawn down as the debt ceiling approached), draining much-needed liquidity from the financial system as these securities settle.

We will again watch for bank deposit outflows placing pressure on smaller lenders and reigniting any regional banking problems.

History suggests markets will have some increased volatility with this surge of securities and the associated liquidity drain.

Charlie Jamieson is the chief investment officer at Jamieson Coote Bonds.