Jason Daw:
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.
Hello everyone, and welcome to this edition of Macro Minutes called Green Light, Yellow Light, Red Light. I'm Jason Daw, your host for today's call, which we're recording at 9:00 AM Eastern Time on June 26th. Two central banks have already cut in the G7, the ECB and the Bank of Canada, and both of those should cut more as the year progresses while the Bank of England and the Fed are likely to join the rate cutting party later this year. At the other end of the spectrum is the RBA, and they're widely expected to keep the cash rate steady this year.
Each country has its own nuances that's going to impact the timing and magnitude of policy changes, which we discuss in this podcast under the theme of green lights: what makes the move, yellow lights: what creates confusion or a pause, and red lights: what could stop them dead in their tracks. So to unpack what's going on and the risks across countries, today I'm joined by Izaac Brook on the US, Cathal Kennedy on the UK and Europe, and Su-Lin Ong for Australia.
I'm going to kick it off with a discussion on Canada. And yesterday's CPI report did have some sticker shock, and it moved the needle from a green light for the Bank of Canada to cut in July to a yellow light. I would say the bad news in the report was it was the first upward CPI surprise that we saw since December. Core CPI measures printed the highest sequentially since December also and, in general, there was broad-based increases and sticky core services inflation.
The good news is that, before yesterday, we had four really good CPI reports, and also the diffusion baskets were stable. So maybe there's a situation where inflation is stickier than previously assumed but, given excess supply in the product and labor markets, it is hard to imagine that inflation remains stuck at current levels or accelerates from here.
Now, overall we think that yesterday's CPI surprise was too small to rule out a July rate cut. The CPI report, it was not great by any means but it wasn't horrible. And our base case probability has gone down. It was 80% before the CPI and now it's in a 50% to 65% range, depending on what the next CPI core numbers print in July. But we think that the market pricing roughly a 1/3 chance of a cut in July is way too low.
So now moving on to some of the specifics using the green, yellow, red light theme. Ahead of the next Bank of Canada meeting, if the next CPI report, the average of the two core measures, if that's below 0.2% month-on-month, I think that'll give the Bank of Canada the green light to cut. In that context, they would view yesterday's CPI report as an aberration rather than a new trend.
Now, if we got a core CPI print that was closer to 0.2%, that would be a yellow light. Almost a pure coin flip for the Bank of Canada, we think. It'd be closer to a 60% chance if it was a soft 0.2%. And if it was a firm 0.2%, closer to 40%. And if it's very close to 0.2, then kind of a 50/50 chance. The challenge with forecasting the July Bank of Canada decision with these CPI scenarios close to 0.2% is that you have the counterbalancing forces of conviction in future disinflation from excess supply versus no urgency from growth and labor market data for them to cut right now.
So probably items like GDP, labor market data, and the Business Outlook Survey, which we're going to get ahead of the next July Bank of Canada meeting, those would likely have more weight in this scenario than in other cases. Now, the red light for the Bank of Canada would be another 0.3% print, or higher in the core measures. In this scenario, the bar for them to cut would be very high and I think they would have a difficult time explaining why adjustment cuts are necessary right now when the economy isn't contracting and inflation is stickier than what they envisioned previously. So with that, now we're over to Isaac to fill us in on his views on the US.
Izaac Brook:
Thanks, Jason. Yeah. So for the Fed, the green light to get that first cut is really still going to depend on inflation as the most important test. More inflation prints like the one we got in the May report, with core CPI coming in below 0.2% month-over-month, is what would give them that green light. 0.16% month-over-month was the pre-COVID average, so prints like that get us back to the 2% target by sometime next year. The other thing in inflation that we're really going to need to see for the Fed to have confidence to start cutting is progress on shelter inflation and OER. That's long expected to be a category that will eventually be providing relief, but that relief has yet to show up.
The other thing that could get the fed cutting is labor and growth slowing down more clearly, but in the near term we think this is a pretty broad-based test, given the Fed still seems highly focused on inflation concerns. And by a broad-based test, we mean not just the unemployment rate rising but also other signs that this is actually a true weakening in economic conditions. So payroll growth slowing, initial claims continuing to rise, consumption also slowing. Signs that whatever weakness is seen in the labor data is also having an impact on broader growth trends.
I think this is probably a good place to flag that our base case for now is still a first cut in December, as we see this economic backdrop as one of normalization, not weakening, at this point and that inflation, while the path is still lower, we think that it might be a little more challenging to be in a good enough place by September or November for them to cut, given election concerns.
If inflation does continue to decline, then as we get later into this year or into next year, then whatever signs of weakness that the Fed might see, it might not have to be as broad to get them to start cutting. And lastly, what would give them the green light to cut would be some sort of other unforeseen shock, whether it's a credit blowout or more bank failures, but something that quickly shifts the balance of risks towards lower growth.
As far as the yellow light, this is the scenario we find ourselves in now, where the fed's mentality is very much hold for longer with inflation remaining a bit stickier. If future inflation prints, core inflation prints specifically, start coming in or continue coming in above 0.2% month-over-month, that becomes a problem as you never get back to 2% if that's the run rate on monthly inflation.
Another thing that would give them cause for further concern would be goods inflation, moving it back out of deflationary territory, which we do see risks to the upside there coming from higher shipping and energy costs and from floated tariff plans. Lastly, something that would give them continued pause on cutting would be a lack of progress on that shelter inflation that I mentioned previously. I think there's a lot of questions and a lot of focus right now of, if that typical historical relationship holds given that the housing market is very unique in this cycle compared to prior cycles.
Other things that will keep the fed in this yellow light, hold for longer mentality is, in general, if there's no urgency to cut. If inflation is looking a bit sticky but labor markets stay healthy, and by healthy I mean wage pressures remaining a bit elevated. Powell mentioned this at the FOMC meeting as something that needs to continue normalizing, so a lack of progress there would probably give them cause for pause, I'll say. Or with payroll growth remaining strong, the unemployment rate moving sideways. Basically anything that indicates that, yeah, we're not in this slow down, weakening stage yet. We're just at a normalization point. And again, if we're still in this normalization stage and inflation remains the predominant concern, there's just no urgency for the Fed to cut, as you have this fear that you end up juicing everything else without helping on the inflation front.
And then lastly, a red light. And to me a red light is what is actively going to get the Fed thinking about hikes again. And obviously the clearest thing there is an inflation reacceleration. That could be price pressures broadening, shelter inflation continuing to not show any progress or perhaps picking back up, or inflation expectations becoming unanchored.
The Fed is always highly attentive to what inflation expectations look like. They've been very steady over the past few months, despite the Q1 inflation bump, but any sign of anchoring there would probably move at least the Fed's conversation back towards hikes. Other things that would shift them to this red light hike concern risk would be a labor market overheating, so wage pressures picking back up, the unemployment rate moving lower, other signs that the labor market is, again, too tight.
And then same on the growth and consumption front. If we see signs that growth or consumption are overheating, that demand-driven inflation is picking back up, that spending is picking back up, then we're firmly going to stay in that red light, hikes might go back on the table mentality.
Jason Daw:
Okay, great stuff. Thanks, Isaac. Next up, Cathal to unpack the outlook in UK and Europe.
Cathal Kennedy:
Thanks, Jason. Well, let me just start with the Bank of England, just because it's the European Central Bank, if you will, that has met... or a major European central bank that has met, most recently having its latest meeting on Thursday of last week. Now, to pick up your traffic light theme, if you will, what the Bank of England really did last week was give us a green light for rate cuts at their next meeting in August.
Now, here in the UK we're in the midst of the general election campaign at the moment. And as part of the rules around that, the Bank of England is limiting its communication. So there was no press conference scheduled for this meeting in any case but, in addition, there was also no interviews, speeches, or briefings from the MPC around the meeting. Now, given the limited communication tools at its disposal, the MPC engineered just about as dovish a hold as it could at its meeting last week.
Now, there's two main ways it did so. The first was changes to its language. Previously it had said it will consider forthcoming data releases and how they inform its assessment of whether the threat of persistent inflation is receding. Now the MPC is saying that, as part of its August forecast round, it'll consider all available information in its assessment of that persistence of inflation. Now, this is significant in two ways. The first is the switch of focus to the August forecast changes the emphasis from what are essentially backward-looking, incoming data to something more forward-looking in terms of the outlook for inflation.
The second is the specific consideration of all available data, which we think dilutes the importance of any single data point. Now, the MPC in effect had to do something if it were to deliver the rate cut that it has signaled since roughly around the spring of this year.
In particular, what has happened is the MPC have told us that they are focused on services inflation as a key measure of domestic inflationary pressures. And, in essence, it has not behaved as the MPC was expecting. In May, services inflation was at 5.7%. At the May MPR forecast round, the Bank of England had expected it to be 5.3% in May. So already were 0.4% above the bank's expectations in terms of services inflation.
So like I said, if the bank was to signal an imminent rate cut, it had to get around the problem that essentially the inflation data wasn't playing ball, if you will. Now, the second way the minutes opened the door or switched on the green light to an August rate cut was by reference to the decision of some of the seven members voting to hold rates, that their decision was finally balanced. So taken together, we think there's an important change of emphasis here from the Bank of England. And in particular, the burden of evidence required for some members to vote for a rate cut has changed.
Now, previously we interpreted the MPC's language in a way that suggests that further improvement in the data in line with the forecasts was required for them to be in a position to feel comfortable cutting rates. As I mentioned, the services inflation data hasn't behaved in that manner. The labor market has cooled, unemployment rate has ticked up to 4.3% here in the UK, and headline CPI inflation is back to target. But like I said, a very important indicator, services inflation, wasn't moving in the way they had expected.
We now think that a rate cut is the default position and essentially, for the light to change to red between now and the August meeting, the next inflation data would have to show services inflation significantly stronger to dissuade the MPC from cutting. So as I said, next MPC meeting on August 1st where we expect to deliver that 25 basis point rate cut, mainly based on its changing rhetoric.
Now, beyond that, we think the traffic light sequence, if you will, will turn amber, with the MPC cutting into a still tight labor market and a recovering economy. And we think the ultimate delivery of rate cuts will be relatively limited, with just 50 basis points in total this year. Now, Jason, you also mentioned the ECB having delivered its first rate cut at its meeting on June 6th. Now, the ECB is, if you will, stuck at an amber light at present.
Numerous speakers have lined up since the June meeting to largely reiterate its data-dependent message, but a back-to-back rate cut in July is looking very remote so, if you will, July is a red light. Instead, governing council members have emphasized staff forecast meetings as the key decision points. The two remaining staff forecast meetings this week come in September and in December, so two left this year. So all eyes are now on the data between now and the September meeting, starting with inflation next week.
Now, we expect that to be unchanged at headline inflation, to show headline inflation unchanged at 2.6% but core inflation coming ticking down slightly to 2.8% from 2.9%. And [inaudible 00:15:08] in line with our expectations would leave both headline and core inflation broadly in line with the ECB's last forecast round, so thus giving a green light to the ECB going in September. So in summary, Bank of England giving itself a green light to start cutting in August. The ECB an amber, needing to see inflation at least in line with forecast to give a green light to September cuts.
Jason Daw:
Okay, great. Thanks a lot, Cathal. Last but not least is Su-Lin on the RBA, where the macro situation seems vastly different in Australia compared to what we're seeing in North America and Europe.
Su-Lin Ong:
Thanks, Jason. It's been a really eventful day in Australian markets following a much higher than expected May CPI print. It's prompted a sharp sell off in bonds. Yields are about 10 to 18 basis points higher by the end of our day, led by the front end, and we're now about 50% priced for a 25 point hike later this year. Headline CPI came in at 4% in May. Consensus was 3.8%. But it wasn't just that higher number, but really the details were pretty poor right across the board. The key core measures that we watched, the trimmed mean, services inflation, non-tradables all stepped up further in May. Trimmed mean was up at 4.4%. Non-tradables came in above 5%. And I think the real eye-catcher was services inflation. That went from 4% to 4.8% in May. It looks like price pressures are really intensifying in services, and that includes things like finance, insurance, housing, and education. And obviously all of these measures are well-above the reserve bank's inflation target.
Our monthly inflation data is still relatively new, and it's not yet the monthly equivalent of the full quarter CPI basket, but the second month of the quarter is more comprehensive and the broad-based nature of some of the increases clearly suggests upside to the full and more comprehensive Q2 inflation, which is due at the end of July. So we've revised up our core inflation number. Our trimmed mean now sits at 1%, and there's probably some upside risk to this. The RBA's last lot of forecasts had their forecast for trimmed mean at 0.8% for Q2. They're likely going to have to revise up again before the August meeting, and at the next August meeting we'll also get that full quarterly statement on monetary policy and an updated broader set of forecasts.
I think what worries us in particular is the higher starting point for inflation occurs amid a still tight labor market, rising house prices, and impending fiscal stimulus. So there are income tax cuts, cost of living measures all kicking in from the 1st of July. And the odds are we'll see further stimulus because we have a Queensland election in October and a federal election due by May of next year. And there's been multiple measures already distributed, and probably some more.
So all of this suggests to us that current policy settings are not restrictive enough at 4.35%. We think the RBA should hike, and it'd be prudent to do so in August but it probably won't because it's such a reluctant hiker and really has been for this entire cycle. It may well tolerate higher inflation and an even slower glide back to target given its labor market focus. We've long argued that this is a risky strategy, and that still remains very much our view. So in terms of the traffic light analogy of this Macro Minutes, the green light in Australia is not for cuts but really what could see us hike. And it would likely be a high Q2 CPI and poor detail that forces them to hike in August.
That's probably a core print in inflation that's above 1%. Something around 0.9% to 1% could be amber, giving this analogy, but it would probably be another very uncomfortable hold. At a minimum, rate cuts are not remotely on the horizon, in our view. We've pushed back the start of some RBA easing to Q2 of next year, probably may, from Q1, but we're still sticking with just two cuts and very modest adjustment. And I think there's a material risk that rates remain at 4.35% indefinitely, mildly restrictive given the amount of excess demand in this economy.
Jason Daw:
Thank you, Su-Lin, and thank you to all our listeners for tuning into this edition of Macro Minutes. Monetary policy expectations has been a key driver of bond yields, the shape of the curve, and also broader risk assets in general, so please reach out to your sales representative or us directly for further insights.
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