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Analysis: Central banks are focused on inflation, at any cost?

• The RBA met last week and raised rates by 25bps, lifting the cash rate target to 0.35%, and signalled further hikes over coming months. The Governor flagged a cash rate of around 2½% over time, which is broadly in line with NAB’s view of the cash rate lifting to 2.60% by the end of 2024. In the meantime, the risk of front loading the hike cycle is real, with the RBA’s detailed forecasts in the SoMP showing core inflation only getting back to 2.9% by mid-2024 and wages growth still rising to 3.7% y/y.
• Importantly, it was not only the RBA that met last week, with the US Fed and BoE meetings also ending with rate hikes. In this Weekly we delve through post-meeting transcripts to answer the bakers’ dozen of questions that my colleague Ivan Colhoun penned last week. The key insight is the commitment of central banks to bring inflation down even with rising recession risks. The BoE will be closely watched, being at the frontier of this potential trade-off given slowing activity, high inflation and real income declines.

Key insights:

• US Fed: The FOMC raised rates by 50bps and is looking to get ‘expeditiously’ to neutral which is seen as being 2-3%. Further 50bp increases are on the table for the next couple of meetings, while a 75bp increase is not being actively considered.
  • The Fed is looking at financial conditions and how conditions are affecting the economy. Importantly, financial conditions indexes include equity, as well as debt and credit spreads. The Fed wants financial conditions to tighten sufficiently, with former NY Fed President Dudley noting “they want a weaker stock market. They want higher bond yields…the stock market is finally catching onto that”.
  • As for how high rates may need to go, the first aim is to get to somewhere around neutral (2-3%) and then assess. Note the Fed’s Bullard has recently called for the Fed Funds Rate to get to 3- 3½% over the next few quarters, while even former uber dove Kashkari notes “If they [supply chains] don’t unwind quickly or if the economy really is in a higher-pressure equilibrium, then we will likely have to push long-term real rates to a contractionary stance…”
  • On the ability of the Fed to achieve a slowing without tipping the economy into recession, Chair Powell said, “we have a good chance to have a soft or softish landing”. However, Powell also said he wouldn’t hesitate to do what was necessary, invoking Volcker. Much will depend on the inflation outlook. As former Vice-Chair Quarles noted, no one remembers what the unemployment rate was in 1971, but what people do remember is Arthur Burns let inflation get out of control.
• UK BoE: The BoE raised rates by 25bps, but is treading a more careful path given the sizeable real income hit to the economy, and signs of activity slowing. In Governor Bailey’s words: “Monetary policy must, therefore, navigate a narrow path between the increased risks from elevated inflation and a tight labour market on one hand, and the further hit to activity from the reduction in real incomes on the other”.The BoE will be watched closely by markets in how central banks trade off inflation and recession risk.

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