A Season of Transitory Goodwill

As we look to 2023, there is much to reflect on. “Transitory inflation” has stuck around forcing central banks into emergency mode. The RBA has increased the cash rate by 300 bps this year and the Federal Reserve has increased the Fed Funds rate by 425 bps. This has sent the price of stocks and bonds falling. The ASX is down around 4 percent and has been as low as 13 percent while the S&P 500 is down around 20 percent.  

So, for our first post in our series of charts of the month, it seems only natural to ask the question, “What next?”. Unveil exhibit A.

Still a way to go

 This chart from Blackrock shows us that in historical terms we are still early in the current upward interest rate cycle for the US (the orange line).

The projected rate for the end of 2022 has now been realised, but compared to most other cycles there is still a long way to go in terms of both further hikes and the length of the cycle. Talk of rate cuts in the first half of next year are likely premature.

The yellow line depicted in the chart is an outlier in terms of its steepness and short length. This is the second upward interest rate cycle by Federal Reserve Chair Paul Volcker, which started in June 1980.

After taking the job in 1979 and failing to wrestle down inflation with his first spate of increases, Volcker went fast and hard in 1980. While this finally got inflation under control, it also helped push the US into a second recession in two years -  the famous “double-dip” recession.

Unemployment remains low

A big contrast between the early 1980s and now is the labour market. The unemployment rate in the US and Australia was around 6 percent at the start of the 1980 recession and peaked above 10 percent in the 1981-82 recession (see chart below). Today, both countries have unemployment below 4 percent and the monthly job figures show little impact so far from the rise in interest rates. This also suggests that there is still some time to go before the RBA and Federal Reserve reaches the terminal rate in the current interest rate cycle.

Misery and the Phillips curve

All this talk about inflation and unemployment has forced economists to dust off superstar charts of yesteryear like Okun’s Misery Index and the Phillips Curve.

The Phillips curve shows an inverse relationship between inflation and unemployment. The logic is that as demand and growth slow, inflation slows, and unemployment rises. The relationship also works in the reverse.

Today, many economists are citing the Phillips Curve to say that unemployment needs to increase more (i.e. the economy needs to slow more) before inflation will come down - “pain before gain”.

The Phillips curve was first published in 1958 by New Zealand economist A. W. Phillips. It remained popular throughout the 1960s and 1970s. However, in the late 1970s it ran into the problem of stagflation: high inflation and unemployment.

The 1970s stagflation was partly caused by the 1973-74 oil shocks, which pushed up inflation and hurt economic growth. It was exacerbated by run-away inflation expectations in the late 1970s and early 1980s. As workers and producers began to expect increasing inflation, they began to push for higher and higher wages and prices. This in turn fed into higher inflation and further impacted economic growth. 

Stagflation is nicely captured by Okun’s Misery Index, which combines seasonally adjusted unemployment and inflation (YoY). It is called the Misery Index, because it shows when consumers struggle with high prices and high unemployment.

The chart below shows the Misery Index for Australia since 1979. The index has been rising since 2021 and while it is far from the stagflation of the 1970s, it has reached a 20-year high. How high will it go?

The only thing that the RBA hates more than inflation is stagflation. Recently, the RBA has been reassured by recent decreases in inflation expectation measures, but the national Wage Price Index (WPI) continues to climb (see chart below) and if the labour market remains tight, the WPI continues to climb, and inflation expectations show any signs of moving up, expect the RBA to use shock and awe with another large increase in interest rates.

“The Board remains resolute in its determination to return inflation to target and will do what is necessary to achieve that.” Philip Lowe, RBA Governor.

Final thoughts

Every interest rate cycle is different. While past cycles are no indicator of future performance, when history is considered alongside the current low levels of unemployment, it does seem like the current interest cycle is going to go higher and longer than many people think. 1970s stagflation seems unlikely as central banks won’t be taken by surprise like they were in the 1970s. However, if inflation proves stubborn we could be in for a period next year of higher inflation and unemployment than we are used to. Trust the dismal science to forecast increased misery in 2023 during the Christmas season!

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