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Analysis: Inflation expectations will see central banks become even more hawkish

• Risk assets have sold off sharply on expectations of the US Fed lifting interest rates more aggressively after hotter-than-expected inflation figures on Friday and signs of inflation expectations starting to lift. Markets now almost fully price a 75bp hike by the US FOMC on Wednesday, with a peak Fed Funds rate seen around 4% by mid-2023.
• In this Weekly we highlight that US inflation has become more broad-based, while rising inflation expectations risk entrenching higher inflation. In this context, central banks will likely become even more hawkish. The flow on impact to Australia is clear, with upside risks to how high the RBA could lift the cash rate relative to our forecasts.
• As for the US CPI on Friday, the two clear implications were that (1) inflation has yet to peak; and (2) inflation pressures have broadened with services inflation picking up. While markets focus on the core excluding food and energy, alternative core measures such as the Cleveland Fed Trimmed Mean printed hot at 6.5% y/y, its highest in the history of the measure that dates back to 1983.
• Perhaps more importantly for central banks is a sense that inflation expectations may be starting to de-anchor. The 5-10y consumer inflation expectations measure out of the University of Michigan Consumer Survey rose three tenths to 3.3%, its highest since June 2008 and is now more than two standard deviations away from its post-1996 average. Economist inflation expectations have also risen sharply recently.
• The Fed of course looks at a range of inflation expectations summarised by their Common Inflation Expectations Index which we have covered previously. Our approximation of this index based on the monthly data flow to date has it at its highest level in the history of the series. It is clear inflation expectations have lifted in the US in the face of recent high inflation and the US Fed is likely to be more aggressive.
• The key policy challenge will be to calibrate policy so as to gradually return inflation to the 2%/2-3% target ranges sought in the US and Australia respectively, while avoiding taking interest rates too high producing a recession and a sustained rise in unemployment. History suggests this is very difficult with markets pricing in a substantial slowdown occurring in 2023.
• In Australia, the RBA’s June Board meeting saw the RBA abandon its assessment that Australian inflation was notably lower than in other countries. And with interest rates well below neutral (still very close to zero actually) and inflation set to track well above target in the near term, the RBA enacted a larger 50bps increase to start returning the cash rate more quickly to a more neutral setting which Governor Lowe has previously indicated may be somewhere around 2.5%.
• Australia’s household sector though is more sensitive than the US to hiking rates given the high share of variable rate mortgages. Higher rates also reduce the theoretical purchasing power of buyers and house prices are likely to decline by 10-15% over the next 12-18 months. Consumer spending should soften in the period ahead.

Chart 1: Inflation expectations continue to lift

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