Speaker 1:

Hello and welcome to Macro Minutes. During each episode, we'll be joined by RBC Capital Markets experts to provide high conviction insights on the latest developments in financial markets and the global economy. Please listen to the end of this recording for important disclosures.

Cathal:

Hello everybody and welcome to this latest edition of RBC's Macro Minutes podcast. Today is August the 13th and I am joined by Su-Lin from our Australian team and Blake from our US team to discuss the current stance of central banks in our respective jurisdictions and how they are responding to the latest inflation challenges.

Su-Lin:

Thanks, Cathal. Let's start with the Bank of England. That was a very unusual rate cut recently, two rounds of voting and a pretty close decision with that five-fourth split. What are your thoughts here? Is the Bank of England done given that hawkish cut?

Cathal:

Thanks, Su-Lin. I'd actually forgotten about the two rounds, unfortunately the excitement around the bank last week, yeah, it's a unusual procedure this time round where we had a 4-4-1 split on the first round of voting and then the governor held a second with a constrained option to get a majority of decision, a slightly unusual outcome, but certainly the bank much more interesting than we thought going into the event. Not least that vote split, a much greater descent against the rate cut than we thought was likely headed a meeting. And as much as the number of committee members who were voting to hold rates, it's also who they were. You now have two of the internal members, Huw Pill and Clare Lombardelli, both dissenting to the hawkish side. Now the significance of that is they are essentially the bank's internal analysis unit. So Clare Lombardelli is the deputy governor for monetary policy and she is the one who compiles or oversees the publication of the bank's quarterly monetary policy report.

Huw Pill is obviously the chief economist. So together they are essentially the people who compile the bank's analysis, particularly that quarterly basis, so significant that they, the ones who were evidenced before the committee who were briefed the committee are the ones who are dissenting in this case, voting is instead to hold rates at 4.25%. The other thing from that came out of the bank meeting continues this pattern we've had since the bank commenced this cutting cycle last August of a hawkish cut, dovish hold, hawkish cut, dovish hold. So that was the very simply the pattern we we've been locked into over the last year or so. What was different this time round was the adjustment of the language. So previously we had the gradual guidance, which we all thought was basically implied the bank would go at this quarterly pace in those meetings where they have a DSAF forecast and they hold a press conference.

But I think the outcome of this meeting to us anyway appeared to have showed that the bank was much less an autopilot going forward. The rate cuts are much less automatic from here on. I think the exact wording was that the time and pace of future reductions in strictness of policy would depend on the extent of which underlying this inflationary pressures will continue to ease. So I think this is a much different stance from the bank than it was previously. Like I said, previously, I felt it was very automatic that as long as the data was allowing it, they will continue to go at this quarterly pace. Now going forward, much less certain as the path of policy going forward. And in particular, whether that quarterly rate still applies. I think the data from here on will have to support rate cuts rather than just not standing in their way.

Su-Lin:

So the onus then is very much on the data going ahead to support further easing. And I'm assuming on that front in particular, at least some better signs in terms of inflation. The challenges there for the UK seem pretty significant. Why is inflation so sticky? Why is it trending upwards in the opposite direction to Australia and a number of other countries? Is that really what the Bank of England is waiting for and looking for progress on?

Cathal:

Yeah, so on the first party, your question, I think the leasing adjusts the way we are viewing the data going forward. I think you said, implied that the bank is more data dependent going forward. I think that's fair enough. I think up until now we'd kind of viewed the bank's communication or indeed the sort of data releases through the prism of will this cause the MPC to adjust a gradual guidance? Will this cause them to accelerate perhaps the rate of the pace at which they are easing policy? I think following this meeting, the view of the data is much more will this allow them to continue to deliver more easing. And I think it's an important distinction as to how we view the data from here on. You mentioned the inflation backdrop here in the UK and I think as you sort of implied, inflation is kind going in the wrong direction for the bank.

So the last print we had, CPI inflation was a 3.6% and the bank expects it to peak at 4% in September. Now a lot of that is administered prices, prices which are regulated by the government or set by the regulatory bodies here in the UK. So stuff like public transport fares and domestic utility bills. But I think the new element which concerned the bank at last week's meeting was the direction of travel and food prices. A lot of concern about food prices for inflation and how that feeds into inflation expectations or the fear that might may well feed into inflation expectations. In respect to domestic inflation, services inflation is broadly kind of drifting sideways should we say as the bank expected, slow progress still on squeezing that services inflation out the system is something we chatted about on previous editions of the Macro Minutes podcast. But what's really, really concerning the bank, I think what's really concerning the hawks on the bank is wages and what's happening to wages of what's still happening with wage inflation in the UK.

So we've had a drift up in unemployment. So the unemployment rate has gone from about 4.2% a year ago to 4.7% here in the latest releases. So there's been... You look across lots of metrics, you can see the least thing in the labor market in the UK. Wage growth is coming down much more slowly and I think what's concerning the NPC and it was said at the press conference afterwards was that wage growth is still above where most of the bank's modeling suggests it should be. So the bank's a bit puzzled why we've got this least thing in the labor market. It's been in place for quite some time now. It was accelerated by the tax changes we saw in the budget and yet wage growth still up around 5% and coming down, picking down very slowly. Now to put down in perspective the bank had a recent conference back in May, the bank indicated that a range of somewhere between three and 3.5% in terms of wage growth was consistent with the inflation target.

So we're still quite a way above that and like I said, quite a way above where the bank's internal modeling thinks it is. So the concern from the MPC is that there is something structural going on in the UK labor market that is keeping wage growth high and preventing it sort of responding to those easing conditions. So that I think is that combination of still high domestic inflation and wage growth which is not playing ball in terms of, well, it should be doing in the bank's minds is what's concerning it. And indeed, sir, we had, if you read the minutes, even those voting for a rate cut last week were not desperately convinced, shall we say, that the disinflationary process was that ingrained in the UK and I think it was Dave Ramsden when the deputy governors in the press conference, he said that inflation was one of those who voted for a rate cut, admitted that inflation was proving more persistent than he thought and it was he who flagged the issue around ways of being above the bank's models.

Su-Lin:

That's interesting. I think when we try and look at if there's any lessons from the UK and what's happening with the Bank of England to Australia, there are some similarities but also some differences so I guess unlike you, we had a fairly boring, we would say, RBA decision this week after some fireworks at the last meeting where there was an unchanged decision in July and a split vote and a lot of us were caught off guard because we thought the case to cut in July was pretty strong given the progress in terms of inflation and that's a little different to the UK. This week we had the cut that we and the markets expected so, 25 basis points, cash rate at 3.6%, a unanimous decision. So quite stark contrast to the Bank of England. And I think really it stemmed from this confirmation from our recent Q2 inflation, that comprehensive inflation report that underlying inflation was now comfortably back within the Reserve Bank's 2 to 3% target range at 2.7%.

Importantly the components that we're all watching and the bank is watching, services inflation, non-tradable discretionary, all moving lower as well. The bank appears a lot more confident that inflation will remain sustainably within target and that's allowed them to cut. So we would say the RBA has been a bit reactive and I think it's understandable given the global uncertainty. There's been a lot of discussion in Australia around where is neutral and the RBA seems quite uncertain on that front with the cut yesterday to 3.6%. They've suggested it's now within a pretty wide band in terms of a neutral range, but there is still a lot of uncertainty over that and I think maybe part of the reason they've been a bit reactive as well is that this is quite a new setup with an independent monetary policy board. It's only been in place for a few months.

It has a number of new members, it is evolving including for the first time publishing unattributed votes and some new communications. So the RBA is still going through a lot of changes. There's a lot of uncertainty still globally for them. Policy is now less restrictive at 360, but they do seem a bit reactive. And I guess to borrow a phrase from you, Cathall, that applies to the Bank of England that the RBA appears to have adopted is this sort of gradual approach to easing policy. We've had three cuts now at a quarterly pace, after each forecasting round we would expect that to continue. That seems to be very much the message coming from the RBA. And so we are anticipating another cut in November and then one more in early 2026 to take terminal to 3.1, which is roughly where we would put neutral.

Cathal:

I was going to ask actually, Su-Lin, the adoption of the gradual guidance by the RBA. In the case of Bank of England, I mean, it kind of reflected sort of in essence kind of some of the uncertainties that came out from the budget last year and then it became an all-encompassing thing, but also it was just due to uncertainty around the disinflationary process in the UK. The backdrop for the RBA sounds a bit better. Why are they sticking to that sort of gradual language? Is it just external uncertainties you mentioned?

Su-Lin:

Yeah, I think it is the global uncertainties, although clearly less so compared to that April period and the extreme volatility. So the global uncertainties are still there, the transmission of tariffs and through to the real economy, in particular China and the US. So there is definitely some uncertainty there, but I think it also reflects, like I said, those other two factors, not really sure where neutral is. So if you're not really sure, you go I think more carefully and you tread more cautiously and you wait for data to confirm that it's appropriate to ease policy. And then also I think this new board, so there's a number of reasons why they're moving more cautiously and gradually. I think part of it also reflects the lower starting point for the cash rate. Unlike a number of other countries including the Bank of England that started their easing cycles last year with cash very restrictive at 5% or higher, we started at 425.

So by definition we don't have as much room to move. And you want to be sure. I think as well to your point around inflation challenges particularly around the labor market, while the inflation picture looks much better in Australia, there are some longer term challenges because we too have quite low productivity. Labor costs remain fairly elevated in Australia. And so while inflation is back within target, how much lower it can push is going to be challenging in a world where productivity in Australia is negative and unit labor costs are elevated. And probably the most interesting thing that came out of the RBA this week was the downward revisions to their assumptions around productivity medium term that makes for some pretty somber reading because ultimately that's what you need to really lift real wages and long run growth and living standards. So those challenges are there as well and I think that's also feeding into their caution.

Cathal:

That sounds eerily familiar to what we have here in the UK in that productivity growth is also in United Kingdom territory for the last couple of years. And indeed, I think one thing from the Bank of England's perspective that struck us over the last year or so is how unresponsive to the growth backdrop it is, we have essentially sort of flacked mildly positive underlying growth here in the UK combined with a tight labor market, low productivity growth and hence this domestic inflation picture that you see. You're due another labor market report this week, do you think that will impact on the outlook for the RBA significantly?

Su-Lin:

I think the labor market comes into focus a bit more now in terms of the RBA and policy deliberations. Now that inflation is within the target range, there is a bit more focus on the labor market. We did get quite a weak print last month in June, the unemployment rate unexpectedly jumped up to 4.3%. That's the highest rate for a few years since late '21. And so there has been some discussion about is the labor market weakening a bit more? We know that it has loosened a little bit over the last six months, but it still remains extremely healthy. There's ongoing employment generation, participation still elevated not far from historic levels, hours work continue to rise and an unemployment rate at 4.3% is still very low by historic standards and arguably pretty close to full employment. So the labor market looks pretty good, not as tight as it was, but it is interesting.

The RBA's forecasts are for the unemployment rate to flatline at 4.3% really all the way through to 2027. I guess there is some concern that maybe the labor market will soften up a little bit. Private demand here has been quite weak over the last 12 months and so we think that the labor market and the suite of data probably is more important for policy deliberations going forward for the RBA, what could get them to move away from gradual or to cut by more than we anticipate is a much weaker labor market. But we are mindful that it will probably take a few months to evolve and play out if that's the case. And so yes, I think there may be a bit more focus on the labor market going forward.

Cathal:

Su-Lin, thank you very much for that. Changing confidence, we're joined by our US rate strategist, Blake Gwinn, as well today. Blake, a picture of loosening labor markets coupled with still challenging domestic inflation picture. Is that one that resonates with you? We found the market reaction to this week's CPI print a little bit curious, so maybe something you'd like to unpick in that.

Blake Gwinn:

Yeah, I completely agree with you, Cathal, I think what we have in the data right now is this kind of very stagflation light type of environment where we are seeing continued softening in the labor market. Now I'd be very careful to characterize that as further softening rather than a more serious deterioration or the start of some kind of self-accelerating process where unemployment starts to rise like we were worried about with the Sahm rule trigger last year or kind of a more typical recessionary pattern. But it's hard to deny that, yes, the labor market is softening and at the same time inflation is a bit problematic. Powell said himself that even if you strip out the impacts, potential impacts or realized impacts of tariffs, that inflation is still likely in an uncomfortable place for the Fed. So I think that's definitely describes the situation on the ground pretty well.

Now the problem with that is that to me that is not a clear home run to start the cutting process. But yes to the second part of your question, I did find the market reaction to CPI a bit curious. We got what, I mean, I think it was a fairly benign print, but if you really go through some of the details, if anything, there were some reasons for the Fed, I think to be a bit concerned. You do seem to have some signs of re-acceleration. The 0.232 month over month print for core, second-largest month over month this year. If you look at things on a three month annualized basis to get a sense of the momentum or the near term trend, that's a 2.8% and kind of rising, you've got the 12-month core CPI at 3.1%. So that's showing some signs of acceleration even when you get down into the breakdowns. We were expecting, and I think a lot of people were probably expecting goods to really be leading the way higher just given some of the tariff pressures.

But this print actually showed services taking higher and services were supposed to be kind of the savior, meaning offsetting some of the tariff related inflation pressure. So you take all that on board, you look at these things like the super core that the Fed used to focus on last year, which is looking problematic. It wasn't a great print. So I mean, I totally agree with the premise of your question that I was a bit surprised at how markets seem to have taken this as kind an open door, not just to cut 25 basis points, but you now have these conversations around a 50 basis point cut and pricing for that in the market is starting to pick up.

Cathal:

Blake, that's great. Thank you. So where do we go from here in terms of the Fed after the NFP print? You said that you still lean towards the Fed delivering a first-rate cut in December, but our confidence in the September hold is certainly lower now, still standing by that?

Blake Gwinn:

Yeah, again, I have to agree with you here, Cathal, we're still leading for a first cut in December. That is still officially our call, but my confidence in that over the last two weeks, basically back to before this last NFP print has certainly fallen. But I guess what I would say is that part of the reason that confidence has fallen is less really the fundamental story about what the data is doing and really more about the narrative itself. I think having those two dissents, having all of this constant pressure coming on the political front, plus now the fact that the market's really kind of pushing the issue, we're more than fully priced for a 25 basis point cut in September. If anything, that's making me a little bit more worried about that September cut than the actual data. So I still lean to the side of a pause in September, but it's a much, much closer call given all of that narrative stuff that I just mentioned.

On the fundamental side, yes, there was a lot of headline shock around the NFP print, particularly around those very large revisions. But as we wrote in a piece that came out after that NFP print, you look at a lot of those revisions is to me they're not really showing something that's particularly cyclical. I think there's a lot of instances that you can point to that are very specific. I would argue idiosyncratic, kind of exogenous type shocks coming from administrative policy or other government policies that again, aren't really a sign that the cycle is necessarily turning. So if I'm the Fed, and I'm looking at roughly half of those downward revisions coming, almost half of those revisions coming from state and local education, which is probably more function of COVID-era funding to hire teachers running out, nothing to do with the state of the business cycle or if you look at some of these things, these categories that are probably related to the real spike in uncertainty around trade that we had in May and June following Liberation Day, that's not particularly cyclical.

So if I'm looking at a lot of those downward revisions and even the low NFP print itself, we just don't know with the state of this labor market what the true, if you want to call it a break-even NFP print. We don't know how many jobs really that the economy needs to create to sustain the economy at this point, just given a lot of the shifts that we're seeing because of immigration policies, because of retirements, these things are impacting the nature of the labor force and we don't know what that means in terms of NFP prints. That's why I think you have Powell very clearly saying, "I think the unemployment rate is the most important metric to look at because it does incorporate some of those shifts in the makeup of the labor market." So I look at all that stuff, the fact that those revisions don't necessarily look cyclical.

The fact that the unemployment rate despite almost rounding up to 4.3, is still at 4.2, a very comfortable level historically, the fact that you don't see permanent layoffs starting to rise, I just don't know that the argument, the fundamental argument for a cut on the labor side, I just don't know that it's particularly pressing. And then you layer in all the inflation risks we kind of talked about in that last question, you layer in some of these tariff risks, the fact that we might see that bleeding in over the next three, six months, continuing to push up the good side, but also some of that probably filtering over into the services side and the fact that we're still at a free handle and seem to be picking up some upward momentum on the inflation side of the mandate.

I think it's very hard for the Fed to really get serious about insurance cuts here. So yeah, we're still holding with December for the first cut. I'm a lot less certain about that, to be totally honest with you. It's much harder to see that. But like I said up at the beginning, a lot of that uncertainty comes more from the shift in the narrative and the fact that the Fed has seemed to not really want to disappoint markets over the last three to four years than a particularly urgent warning sign coming from the labor market.

Cathal:

Blake, many thanks for that. [inaudible 00:24:53] from your perspective. And with that, we bring this edition to Macro Minutes to a close. We hope that you enjoyed this edition as much as we enjoyed hosting it and hope that you'll join us again in the future for further discussions of markets and policy.

Speaker 1:

Thank you everyone for joining this episode. If you have further questions, you can reach out to us directly or via your sales coverage or visit RBC Insight to read our content.

Speaker 5:

This content is based on information available at the time it was recorded and is for informational purposes only. It is not an offer to buy or sell or a solicitation and no recommendations are implied. It is outside the scope of this communication to consider whether it is suitable for you and your financial objectives.