The end of a unique and brutal interest rates cycle is close

In the US, at least, it appears that the end of the pandemic-inspired outbreak of inflation may now be in sight and, with hindsight, the past two years might eventually be seen as an aberration rather than a conventional inflationary episode.

The June headline inflation rate in the US was 3 per cent, the lowest rate since March 2021, and the “core” rate (excluding volatile food and energy prices) was, at 4.8 per cent, also the lowest in two years. On a month-on-month basis, headline inflation was 0.2 per cent – 0.18 per cent if run out to two decimal places – and core inflation edged up 0.158 per cent.

It is now more likely that Jerome Powell’s Fed will raise the federal funds rate for a final time this year at its meeting later this month, rather than the two or more rate rises it has only recently been signalling.
It is now more likely that Jerome Powell’s Fed will raise the federal funds rate for a final time this year at its meeting later this month, rather than the two or more rate rises it has only recently been signalling.Credit: AP

While the numbers are for only one month, they are encouraging and sharemarket and bond market investors were encouraged, with shares up and bond yields down.

To get to the US Federal Reserve’s target range for core inflation it requires monthly increases of just under 0.2 per cent, so the US is now tracking close to that target.

The immediate conclusion of Fed watchers after the data was released is that, if there are to be further increases in US interest rates, it is more likely that the Fed will raise the federal funds rate for a final time at its meeting later this month, rather than the two or more rate rises it has only recently been signalling.

It’s not that surprising that the US inflation rate, however measured, is falling faster than the Fed or the markets had been anticipating.

Monetary policies take time – a year or more – to bite and so the effects of 15 months of rate rises (10 of them in the US and 12 over less than 14 months here) were going to take time to show up. It was always going to be the second half of this year when the cumulative effects of the monetary policy tightenings progressively emerged.

What’s surprising about the US experience, and perhaps encouraging for Australia, is that, so far at least, the inflation rate is waning without the sharp jump in unemployment or big slump in economic growth that central bankers would normally expect and look for as lead indicators of a decline in inflation.


US unemployment is at record lows and its economy has been growing at a respectable 2.3 per cent. Here employment is also near historical lows and the economy is growing at a similar rate to that of the US.

That suggests that it may be possible to manage this burst of inflation out of the system without the economic and social damage that the defeat of previous bouts of inflation, like “the recession we had to have” of the 1990s in Australia, have wrought.

It also suggests that this episode of inflation might be different to those of the relatively recent past.

The US is seeing signs that it is winning its war on inflation.
The US is seeing signs that it is winning its war on inflation.Credit: Bloomberg

When inflation first started to develop momentum in the advanced economies during the first phase of the pandemic, the consensus among central bankers was that it would be a “transitory” phenomenon, one caused by the sudden and unforseeable disruption to supply chains that would end once the worst of the pandemic had passed.

What they misjudged was how severe and prolonged those disruptions would be, along with the effects of the massive injections of liquidity and cash into their economies from the central banks’ own actions and the unprecedented fiscal responses of their governments.

That meant they were slow to recognise the potential for inflation to get out of control. In the US, the headline rate peaked at 9.1 per cent just over a year ago. Here it peaked at 7.8 per cent last December.

While it took much longer than anticipated, global supply chains and the cost of accessing them have largely returned to pre-pandemic levels.

A significant influence over inflation rates during the past two years has, for instance, been the prices of cars, new and used.

The pandemic triggered reduced production in expectation of reduced demand and a dearth of the semiconductors essential for modern cars. That led to shortages and long waiting lists for new vehicles and a significant spike in the cost of used cars.

In the latest data, the prices of new cars flat-lined month-on-month and used car prices were down 0.5 per cent.

Another indicator of how far along the path towards pre-pandemic settings was provided by the industry that was arguably the most disrupted by the pandemic. Airfares in the US fell 8.1 per cent in June.

As we’ve seen in this market, the global aviation industry has gradually returned much of the capacity it mothballed during the pandemic.

Qantas’ domestic capacity is now back to pre-pandemic levels, for instance, and its international capacity is expected to be back to pre-pandemic levels by March next year. As the industry’s capacity increases prices will inevitably fall.

The Fed isn’t about to declare victory on the basis of one month’s figures but the US inflation rate has been falling, albeit slowly, for the past 12 months. While it will still probably raise the federal funds rate by another 25 basis points this month, beyond that it will start to consider whether further increases risk unnecessary economic damage.

Wall Street jumped on the news
Wall Street jumped on the newsCredit: Reuters

Among the central banks that moved earliest and most decisively was the Reserve Bank of New Zealand. This week it kept rates on hold (its cash rate is 5.5 per cent against our Reserve Bank’s 4.1 per cent) for the first time in two years, truncating a series of 12 consecutive increases.

New Zealand, which has been in technical recession (at least two consecutive quarters of economic contraction) since the December quarter last year may be the first of the central banks to end this cycle although, as is probably going to be the case with most of the central banks, interest rates are likely to remain at their peak, or terminal, levels until well into next year as the banks ensure that the hard-won gains are locked in.

The RBA’s much-maligned governor, Philip Lowe, who has tended to be more cautious than some of his more hawkish peers over the past year, indicated this week that further rate rises here might not be necessary. It remains to be determined, he said, whether monetary policy has more work to do.

Given the novelty of this inflation episode, the potential for unexpected developments in both directions given the brittleness and volatility of the global economic and geopolitical environments and the risk of monetary policy overkill at this late stage in the rate cycle, a cautious approach would appear the pragmatic and sensible approach at what may come to be regarded as the pivotal phase of this cycle.

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