Market calls: a lid on inflation

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The US and UK central banks are managing the most solid recoveries in the developed world but they are hamstrung by falling inflation expectations.

"Evidence is emerging [in the UK and US] of a pick-up in labour cost growth which should lift inflation closer to targets over coming months."
ANZ Research

Now evidence is emerging of a pick-up in labour cost growth which should lift inflation closer to targets over coming months.

In Australia, the Reserve Bank expects spare labour market capacity to keep a lid on local inflation for some time, despite some indicators suggesting a slow improvement in labour market conditions.

RBA Governor Stevens recently acknowledged a lack of inflationary pressure in the economy. Importantly, he said there are “sufficient spare labour resources such that we could probably enjoy a couple of years of non-mining sector growth somewhat above its trend rate before we needed to worry too much about serious inflation pressure”.

He also confirmed current monetary policy settings are likely be in place for some time yet. The interpretation for markets is rate hikes could be some time off

In ANZ Research’s view, the local unemployment rate is likely to remain high for some time but forward-looking indicators suggest the rate of deterioration in the labour market has slowed.

Offshore, growth is solid in both the US and UK economies and a degree of self-sustainability is emerging. Business investment is rising and consumer confidence and spending are improving as labour market conditions tighten.

The central banks of both regions, however, are concerned about subdued inflation and that this could further dampen inflation expectations. The appetite to begin lifting interest rates therefore remains limited. We see the first half of 2015 as an opportune time for the Bank of England and Federal Reserve to start slowly raising policy interest rates.

Closer to home, the long-awaited free trade agreement between China and Australia was sealed last week. It is difficult to quantify the overall benefits to each economy, in part due to incomplete detail.

Importantly, the FTA plays to the strengths of both Australia and China, although China’s announcement of coal use restrictions is negative for Australian producers.

A key differentiating factor of the China FTA compared with other Australian FTAs is that it is with our largest trading partner and demand, outbound investment and tourism are expected to remain strong.

The Australian dollar continues to consolidate near multi-year lows but the deterioration does not look out of place relative to weak fundamentals. Rate cuts in China have not materially changed the outlook for the currency, which remains over-valued.