Higher food and energy prices feeding higher consumer inflation globally

• US underlying consumer prices up 6.5 percent over the past year to March
• US Federal Reserve underlying core inflation target is 2 percent
• Annual Eurozone inflation at a record high of 7.5% in March
• RBA likely to raise interest rates in June following revised inflation forecasts in May
• Australian markets well primed for return to normalised interest rate settings.

US CPI up 8.5 per cent in March

Higher fuel and food prices in the US have pushed consumer prices to levels not seen since 1981, adding to the pressure on the US Federal Reserve to hike interest rates more aggressively than previously envisaged. The 8.5 percent increase in the cost of living in March follows a 7.9 percent lift in February. The US Labor Department’s figures for March showed that gasoline prices jumped 18.3 per cent, the largest gain since 2009. Economists believe that the war on Ukraine and related Russian export sanctions are directly responsible for the soaring energy and food prices.

The Federal Reserve, like all Central Banks, will focus on the underlying core prices paid by consumers, which increased 0.3 per cent from a month earlier, and 6.5 per cent from a year ago. Alarmingly, this compares to the Fed’s 2 per cent underlying core inflation target, which is the Central Bank’s “most important task,” according to the Federal Reserve governor, in a recent Wall Street Journal interview.

Making matters more difficult for American workers, wages are failing to match inflation. Inflation-adjusted average hourly earnings dropped 2.7 per cent in March from a year earlier, the 12th straight decline, according to wage data released on Tuesday.

This situation creates a policy dilemma for the US Federal Reserve. The dilemma is that economic activity will contract as consumer spending declines in response to the higher cost of living, while simultaneously the Federal Reserve is forced to hike interest rates. Higher interest rates at a time of declining economic activity increases the risk of an economic recession. A delay by The Federal Reserve to increase interest rates now may require a catch-up in rate rises, further exacerbating the likelihood and severity of a US economic recession.

European Central Bank

The European Central Bank (ECB), as the central bank of the 19 European Union (EU) countries is grappling with a similar dilemma faced by the US Federal Reserve.  

Annual Eurozone inflation hit a record high of 7.5% in March, compared to 5.9% in February. Like the US, significantly higher energy and food prices have pushed inflation to extreme levels, as Russia’s war on Ukraine sends commodity prices soaring. The ECB is faced with a difficult policy decision at its next policy meeting on Thursday because the economic impact from the Russia-Ukraine conflict is much more severe in Europe, than anywhere else in the world. This is because Europe is heavily dependent on Russian gas for its energy needs and any threat to the supply of energy to European factories is likely to have a severe negative impact on economic growth and employment, as well as inflation. This heightens the risk for stagflation throughout the EU.

Like the US Federal Reserve’s policy dilemma, any delay by the ECB in hiking interest rates given uncertainty over the economic growth impact from the Russia-Ukraine conflict, may require higher interest rates in the future at a time when the EU can least afford them. 

Implication for Australian interest rates

Australia is not immune from events impacting the US and Europe, particularly regarding interest rates and inflation. The 10-year Australian government bond rate presently yields 3 percent, up from   1.07 percent in August 2021 and 1.67 percent on 1 January 2022. The Australian bond market has spoken and is clearly signalling higher inflation and rising interest rates, from current levels. The Australian economy, buoyed by rising export prices for our major commodity exports, and near full employment, is in a strong position to absorb higher interest rates to deal with Australia’s rising inflation. 

US inflation is widely expected to remain near 6 per cent throughout the year, implying a rise of half a percent in US interest rates at the Federal Reserve meeting in May. The market consensus is for a half a percent rate rise in May. The ECB and the Reserve Bank of Australia (RBA) are likely to quickly follow any rate rise announced by the US Federal Reserve next month. 

Accordingly, Australian households should prepare for the RBA to announce a quarter of one percent rate rise in June.  The RBA’s own inflation forecasts to be released in May are likely to lay the groundwork for higher interest rates at its first meeting immediately after it revises its inflationary outlook. A move to higher interest rates following an extended period of near zero interest rates should not come as a surprise to equity or debt market participants and is unlikely to have a major or lasting negative impact across all asset classes. As the old investment adage goes, “if it’s in the news, it’s in the price?” 

There are certain asset prices trading at elevated price levels that can be explained by low interest rates. However, quality assets with sound underlying fundamentals within a diversified investment portfolio, are likely to weather the shift to normalised interest rate settings in the year or two ahead.

This Post Market Wrap is presented by Kodari Securities, written by Michael Kodari, CEO at KOSEC.