The RBA’s decision to lift cash rates by 0.5% was both expected and factored into markets. At the current 1.35% level and the expected rise in inflation to 7% by year-end, there can be no claim that the RBA is on the front foot in fighting inflation. Arguably, both Monetary Policy (negative real interest rates) and Fiscal Policy (deficit of 2.5% of GDP) are supportive of economic activity. However, the problem for markets is that the level of support has been severely cut back.
Since the GFC, Central Banks have been pumping their economies with liquidity and a range of unconventional support mechanisms. Over that period the theoretical economic expectation was that inflation would develop as a natural consequence of printing money (QE) and/or excessive credit creation that drove demand against limited supply.
However, the actual outcome for the inflation cycle was dramatically different. Extremely low levels of inflation evolved, and consumer and corporate credit demand was a significantly lesser problem than investor credit demand. The result was asset price inflation.
Asset price inflation was seen across investment and speculative asset classes. Negative yielding bonds, the emergence of bitcoin (with no intrinsic value), PER expansion in equity markets and yield compression across debt, credit and property markets, were all indicative of asset inflation.
Some of that asset inflation should have been captured in consumer price inflation. However wage rates were relatively stable and residential property surges were offset by the historic low cost of mortgages. The Consumer Price Index became a construct where manipulation of weightings gave the impression that the cost of living was stagnant. As the cost of healthcare, childcare, aged care, education, power and other basic services kept climbing, the cost of goods imported from China and emerging economies fell. Oil and therefore petrol prices were held down by abundant supply.
This benign consumer price inflation period has now come to an end. Consumer prices are surging just as asset price inflation has collapsed. The surge in consumer inflation is occurring as Central Banks talk of a necessary adjustment to interest rates to subdue inflation. The outlier is the Bank of Japan, which has steadfastly retained its long held QE and interest rate targeting policy. It seems to be ignoring inflation and inflation appears to be avoiding Japan – at this point!
The answers are drawn from a few observations. These are:
First, the extended length of time that Central Banks maintained supportive or loose policy.
Second, the excessive dropping of interest rates to levels that should never have been reached.
Third, the rapid change in energy management by governments targeting decarbonisation in an effort to combat climate change; and
Fourth, the emergence of inflation from China and energy markets (set off by the Ukraine war) and exacerbated by COVID lockdowns.
The causes of consumer inflation are well captured in the next chart. Across the US and Europe, the cost of energy has generated 30% to 60% of the inflation surge. The cost of imported goods from China has had some effect, and in the US the cost of labor (wages) is feeding into the cost of services.
At this point, Australia’s inflation surge is driven mostly by petrol, energy and food. It will be added to by wages (following the Fair Work Commission judgement in mid-June that minimum wages should increase by 5.2%) that will feed into services costs as we battle with a unique shortage of labour supply.
Initially, the reaction of asset markets was acute with severe bond and equity market corrections. However in the past few weeks, long term bond yields have declined (bond prices rise) as fear of recession replaces fear of inflation. In the US, the 10 year Treasury bond peaked at 3.5% in mid-June and has retreated to 2.9%. Meanwhile the interest rate futures that trade off expectations of future cash rate settings have also receded markedly.
The US bond market yield curve is becoming flatter between 2 year and 10 year maturities. The bond market pundits say that a recession is likely in the US (if not across the developed world) if shorter dated yields (up to 3 years) trade above longer dated yields, creating an inverse yield curve.
The following charts show the contraction in investment asset values and places them in historic context.
First, the return from US ten year Treasury bonds over the last 6 months was the worst in 240 years!
The world bond index over the last 12 months has delivered the worst return since the Second World War.