US Federal Reserve to keep hiking rates in fight against inflation

US inflation is far too high for the Fed to stop aggressive rate hikes, while Australia’s strong inflation momentum appears to be continuing.

US inflation is far too high for the Fed to stop aggressive rate hikes and Australia’s strong inflation momentum appears to be continuing in the September quarter, a leading economist warns.

US CPI data rose less than expected for July, pushing the S&P 500 up more than 2 per cent to be almost 16 per cent above its 18-month low in June, while the Nasdaq entered a new bull market.

Australia’s S&P/ASX 200 rose 1.1 per cent to a two-month high of 7077.1 points. The Aussie dollar rose more than 2 per cent to US71.09c as the US dollar fell.

Federal Open Market Committee members Neel Kashkari and Charles Evans said the CPI data didn’t change their expectations of higher US rates. Mr Evans said inflation was “unacceptably high” and the Fed would be lifting rates this year and into next to “make sure inflation gets back to our 2 per cent objective.”

GSFM investment strategist and former Blackrock head of fixed income Stephen Miller said that while the CPI data lowered market expectations for the peak of US interest rates, with core CPI still high, the issue was how quickly inflation falls below 3 per cent.

Markets trimmed expectations for a September US rate hike 75 basis points to 50, and saw rates peaking near 3.6 per cent per cent by early 2023, before falling to near 3 per cent by end-2023.

“That looks somewhat optimistic in my view,” Mr Miller said.

“What remains troubling and what will continue to focus the minds of the Fed is the continued strong momentum in ‘underlying’ measures of inflation.”

Measures of the underlying inflation pulse “continue to show extraordinary momentum and no retreat from the historically high levels recorded in June”, with the Cleveland Fed measure of trimmed-mean inflation remaining at 8.4 per cent on a three-month annualised basis.

US Federal Reserve Board chairman Jerome Powell. Picture: AFP

“Such readings suggest that inflation is more than just a few outsized price increases in selected commodities or ongoing supply chain blockages and that any retreat will be smooth as those influences unwind,” Mr Miller said.

“That sort of inflation pulse is indicative of an inflation inertia – last seen in the late 70s and early 80s – that may yet prove a lot more difficult to arrest than markets are currently contemplating.

“Current pricing for the Fed therefore is not implausible, but in my mind is located at the very benign end of the risk continuum.”

With market-based expectations of inflation implying a fall to around 3 per cent within two years, the real policy rate “struggles to get above zero”.

“That looks to be some way from the ‘restrictive’ levels the Fed judges to be necessary to contain inflation,” Mr Miller said.

“Even more so if, as seems to be the case, inflation is ‘sticky’ and declines only grudgingly toward 3 per cent.”

In his view the nominal policy rate may need to go higher than markets are expecting, albeit were the more benign developments evident in the July CPI report to be repeated in August and underlying measures turned down, expectations would be “more plausible.”

Meanwhile Australia’s inflation impulse is running 6-12 months behind the US but is closing rapidly.

June quarter headline CPI hit 6.1 per cent and underlying CPI hit 4.9 per cent – the highest levels since the early 1990s, and Reserve Bank forecasts projected a peak of 7.8 per cent this year.

Worryingly, there are several indications that strong inflation momentum is continuing.

Melbourne Institute’s inflation gauge showing trimmed mean inflation expectations remaining near 6 per cent in July and August despite a fall from 6.7 per cent in June.

NAB’s July Business Survey showed extraordinary momentum in wages and prices, with retail prices rising by 3.3 per cent quarter-on-quarter, and labour costs and business purchase costs showing even more worrisome rises of 4.6 per cent and 5.4 per cent respectively.

“That cocktail of price measures is indicative of the same sort of inflation inertia that was last experienced on a global scale in the late 70s and early 80s,” Mr Miller warned.

“Like the US, it may prove a lot more difficult to arrest than markets are contemplating.”

Mr Miller said 50 basis point rate hikes “must be on the agenda” for RBA meetings in September and October, and possibly November, if September quarter CPI data confirmed the inflation momentum.

“Were such increases followed by a 25 basis point increment in December, that would mean the cash rate ends the year at around 3.6 per cent compared with a market expectation of around 3.2 per cent,” he noted.

“Like almost every other central bank, a late start, and an overly conservative approach to the withdrawal of historically high levels of monetary stimulus, has put the RBA beyond the realm of ‘first best’ solutions. It now finds itself searching for a ‘least bad’ or a ‘second best’ outcome.”

Mr Miller argued: “If there was a lesson to be learnt from the 1970s inflation episode, it is that a more tepid approach now might necessitate an even more aggressive approach down the track with an attendant greater likelihood of more substantial macroeconomic dislocation in terms of growth and employment.

“In this context, if the current policy rate is indeed well below the neutral rate and there is a pressing requirement to get to neutral and maybe beyond that to ‘restrictive’ territory, then the best approach is to do so as quickly as possible.”

The ABS will publish the first stand-alone monthly CPI Indicator in October, alongside the quarterly CPI release.