US and Aussie central banks to quicken bond taper

US Federal Reserve; Purchasing managers’ indexes; RBA Governor speech

The US Federal Reserve (‘the Fed’) left its target range for the federal funds rate unchanged at 0-0.25 per cent, but Fed officials see as many as three interest rate hikes in 2022. The Fed said it will reduce or ‘taper’ its asset purchases, buying US$60 billion per month of bonds in January, down from December’s rate of US$90 billion.

The preliminary IHS Markit Australia Composite Purchasing Managers’ index (PMI) eased from 55.7 in November to 54.9 in December. A reading above 50 indicates an expansion in activity.

The Reserve Bank (RBA) Governor Philip Lowe delivered a speech to CPA Australia Riverina Business Conference – Wagga Wagga – entitled “The RBA and the Australian Economy” – with a focus on its bond-buying program.

What does it mean?

• The US Federal Reserve (‘the Fed’) this morning left its target range for the federal funds rate unchanged at 0-0.25 per cent. But the central bank announced it will scale-back or taper its asset purchases, buying US$60 billion per month of bonds in January 2022, down from December’s rate of US$90 billion, amid a continued rise in inflation and an improving labour market. In fact, core consumer prices (excluding food and energy prices) lifted by 4.9 per cent over the year to November, the strongest annual pace since 1991, well above the Fed’s 2 per cent inflation target. In his press conference, Fed Chair Jerome Powell said there is a “real risk high inflation becomes entrenched” after previous references to “transitory” inflation were dropped from his commentary.

• The more aggressive unwinding of its monthly asset purchases has put the Fed on track to conclude its Quantitative Easing (‘QE’) program in March 2022. That said, policymaker’s have kept their options open, saying they could further adjust the pace of asset purchases, “if warranted”.

• In his press conference, Chair Powell reiterated hikes in the federal funds rate would occur after tapering ends in March 2022, but cautioned that policymaker’s are not thinking about hikes right now. So with ‘lift off’ likely occurring after March, investors quickly turned their attention to the Fed’s accompanying projections, which showed that officials expect three quarter-point increases in interest rates next year, after holding borrowing costs near zero since March 2020. Commonwealth Bank (CBA) group economists expect the Fed to increase the federal funds rate four times in 2022, starting in May 2022, to an eventual target range of 1.00 per cent to 1.25 per cent.

• Chair Powell was keen to emphasise that “[US] economic activity is on track to expand at a robust pace this year,” adding, “the economy has been making rapid progress toward maximum employment.” Investors reacted positively to the Fed’s announcement on speculation that policy tightening will help combat surging prices without derailing economic growth. The policy moves were already largely priced into sharemarkets. At the close of US trade, the Dow Jones index rose by 383 points or 1.1 per cent. The S&P 500 index lifted by 1.6 per cent, closing near it’s all-time high, with the Nasdaq index higher by 328 points or 2.2 per cent. All three were in negative territory for the day before the central bank’s decision.

• And longer-dated US 10-year treasury yields rose by 2 points to near 1.46 per cent with US 2-year treasury yields steady near 0.66 per cent at the US close, with money markets shifting to price in three quarter-point hikes by the end of 2022. Greater investor risk appetite saw the Aussie dollar lift from overnight session lows near US70.96 cents to highs near US71.75 cents and was near US71.70 cents at the US close.

• RBA Governor Philip Lowe returned to his home town of Wagga Wagga today, delivering speech entitled, “The RBA and the Australian Economy” at the Riverina Business Conference. In his speech, Governor Lowe said the central bank was considering three different options for its bond-buying program ahead of February’s formal review. But he stressed, “we have made no decision yet” on whether to accelerate the tapering of purchases or to scrap the program altogether. The Governor also pushed back on market pricing for a rate hike in 2022, reiterating that the Board “is prepared to be patient” and “will not increase the cash rate until inflation is sustainably in the 2-3 per cent target range,” as “we are a fair way from that point.” He also stressed that other countries have higher inflation than Australia due to more elevated energy prices and wages. Of course, higher wages and lower unemployment are both considered pre-conditions to achieving sustainable inflation near the mid-point of the RBA’s 2-3 per cent target range.

• Activity in Australia’s manufacturing and services activity both continued to expand in December, albeit at a slower pace. Encouragingly, employment levels grew at a faster pace, according to IHS Markit economists, but input cost and input price inflation hit fresh record highs amid continuing supply chain disruptions.

What do you need to know?

IHS Markit Purchasing Managers’ indexes (PMIs) – December

• The preliminary IHS Markit Australia Manufacturing Purchasing Managers’ index (PMI) eased from 59.2 to 57.4 in December. The Services PMI fell from 55.7 in November to 55.1 in December. And the combined or composite PMI eased from 55.7 in November to 54.9 in December. A reading above 50 indicates an expansion in activity.

• According to IHS Markit economists: “The Australian economy maintained growth at a strong rate in December, according to the IHS Markit Flash Australia Composite PMI, though the growth momentum eased from November with some pent-up demand having been unleashed.”

• “Supply issues meanwhile persisted, with lead times continuing to lengthen and reports of shortages persisting. This led to a surge in price pressures for private sector firms and affected business confidence alongside lingering COVID-19 concerns for private sector firms. While some of the inflationary pressures may be attributed to the reopening effect, it will be worth watching for any drag on business activity into the new year.”

• And, “The climb in employment levels was also a positive sign with private sector firms across both the manufacturing and service sectors hiring at faster rates in December. That said, instances of labour shortages had continued to surface while service providers also widely cited rises in wages contributing to higher input costs.”

Reserve Bank Governor Philip Lowe speech: “The RBA and the Australian Economy”

• Reserve Bank (RBA) Governor Philip Lowe delivered a speech to CPA Australia Riverina Business Conference in Wagga Wagga entitled “The RBA and the Australian Economy.”

Australia’s central bank is considering three options for its bond-buying or quantitative easing (‘QE’) program ahead of its February 2022 review: “The first option, namely to reduce the pace of purchases from mid-February with an expectation of a likely end point in May, is broadly consistent with the Bank’s forecasts in November for employment and inflation. If better-than-expected progress towards the Board’s goals was made, then the case to cease bond purchases in February would be stronger. Alternatively, if progress is slower than expected, or if the outlook becomes more uncertain, the case for retaining flexibility and reviewing again in May would be stronger.”

• On the interest rate outlook: “The second point that I want to make is that the Reserve Bank Board will not increase the cash rate until actual inflation is sustainably in the 2–3 per cent target range. We are still a fair way from that point. In our central scenario, the condition for an increase in the cash rate will not be met next year. It is likely to take time for that condition to be met and the Board is prepared to be patient.”

• CBA Group economists favour a further taper to $A2 billion per week until May 2022, but acknowledge the risk has increased that an end to the program is announced.

Published by Ryan Felsman, Senior Economist, CommSec