The key development through the fourth quarter was a reversal of the themes that had prevailed throughout the first 9 months of the year: equity markets stabilised; bond yields declined (after a sharp upward move in the first part of October); and the USD exhibited weakness after strong appreciation after a sustained period of strength.
Those developments largely reflected emergent positive news on US inflation which by year-end was showing signs of meaningful deceleration.
Inflation developments in the US would seem to represent a strong vindication of the Fed’s aggressive approach to the containment of inflation. The fight against inflation might not yet be over but certainly the inflation portents in the US are encouraging and suggestive of a peak in the policy rate of around 5% from 4.50% at year-end.
In essence the difference between markets and the Fed is the first easing point. By and large Fed officials think that a policy rate above 5.00% would endure until the end of 2023 even with a projected slowdown in activity. Markets are implicitly less sanguine on activity and see the policy rate closer to 4.50% or lower by year-end.
The big question is whether policy rate increases in 2022 push the US economy into recession in 2023. Recession talk was around for much of 2022, particularly in the second half of that year when the Fed embarked on four successive 75bp policy rate increments. Thus far, the data has not validated that view with the labour market showing unexpected resilience.
Locally the Reserve Bank unexpectedly dialled down the size of the monthly policy rate increment to 25bps in October. However, uncertainties persist on the domestic inflation front with high-frequency price and wage data indicating inflation pressures persisting into 2023 which may mean some upside risk to the terminal policy rate in Australia. Markets currently expect a terminal policy rate of around 3.60%. The current rate stands at 3.10%.
18 January 2023