The Narrow Path Is Getting Narrower

The Federal Reserve deployed a stepped-down 25bp hike last week, with the fed funds rate now above the central bank's preferred measure of inflation. Historically, the Fed has tended to lift the funds rate above the prevailing inflation rate before ending the tightening cycle.

• While aggressive tightening appears to have given the Fed capacity to shift back to a more gradual approach, the rationale for the RBA’s recent step down in the pace of tightening appears less obvious.

Fig. 1: Fed Funds Rate Vs. U.S. Core PCE

Source: MNI - Market News/Bloomberg

• The RBA stepped down to 25bp tightening increments in October with the cash rate just above the “at least 2.50%” estimate of the neutral rate cited by RBA Governor Lowe, flagging a deteriorating outlook for the global economy and the desire to proceed cautiously considering “a substantial cumulative increase in interest rates since May.”
• Since then, the economic environment has strengthened with China reopening, as well the U.S. and Europe looking more resilient, while the domestic economy remains robust (even as house prices tumble and consumer sentiment remains depressed). Moreover, inflation remains elevated alongside a concerning shift towards domestic price pressures, meaning that at 3.35%, it would be difficult to argue that the cash rate is meaningfully restrictive (the real cash rate looks to remain significantly negative until end-24, adjusting for RBA inflation forecasts).

Fig. 2: RBA Cash Rate Vs. Australian Trimmed Mean CPI

Source: MNI - Market News/Bloomberg

• It is hard to argue with the logic behind gradual policy tightening. However, it appears best to be adopted once policymakers “feel on top of the problem” otherwise the policy path to keeping the economy on an even keel while returning inflation to target will get even narrower.