- Inflation has largely been beaten, but Trump policies pose a risk to its return.
- US Fed pauses interest rate cutting, as inflation concerns rise.
- RBA likely to cut interest rates in February (with more cuts likely in 2025!).
- Global economy mixed, US strength, Europe fading and Australia somewhere in the middle.
The Big Picture
In many countries, including Australia and the US, inflation has largely been beaten. However, there are some data points that are causing some to question whether inflation could return again in the not too distant future.
In the US, the statistical agency produces separate data on the Consumer Price Index (CPI) measure of inflation, an index for shelter (largely rent), and CPI-less-shelter. For the last seven months, inflation in the official CPI-less-shelter inflation has been comfortably below the Federal Reserve’s (Fed) target of 2% p.a.
Except for three months (March to May 2024), US CPI inflation-less-shelter has been below the 2% target since May 2023. The average over the last 19 months (including the three aberrant months) is only 1.6% p.a.! The largest read in those three months was 2.3% p.a. So, what is the problem?
Residential rents in the US account for about one third of the CPI. But because of the way it is calculated, rent inflation only falls slowly after a spike. The Fed has acknowledged this fact in a recent research paper and its chair, Jerome Powell, discussed this point at a press conference last year. Powell noted other agencies calculate rent inflation differently (and hinted possibly better) but he said they were not about to change. Perhaps they will after this cutting cycle is well and truly over!
Rent inflation peaked at 8.2% p.a. in March 2023 and has fallen each month since – except for two small monthly increases – and it now stands at 4.6% p.a. It is highly unlikely rent inflation would increase with a lower interest rate. Indeed, the opposite is probably the case, as owners might pass on rate changes to their tenants. At the current speed of the falls in inflation, it could be 2026 before we see aggregate shelter inflation to get close to 2% p.a. In summary, inflation is not sticky, the calculation for shelter inflation is deficient!
The Fed did not cut rates again in January after three successive cuts totalling 1.00%, or 100 bps (basis points), to stand at a range 4.25% to 4.5% p.a. As it happens, the RBA interest rate in Australia is 4.35% p.a. and there have been no cuts (yet) in this cycle.
Models exist for predicting the chance of future Fed cuts based on the current market prices of interest rate futures and options. One such model prices an 80% chance of a single cut by May and an 80% chance of a second cut by the end of this year.
Powell is hesitant to cut US interest rates again for two reasons. First, economic growth as measured by Gross Domestic Product (GDP) is strong, (the latest estimate is 2.3% p.a. for the December quarter and 2.8% p.a. for 2024) and jobs are holding up (256,000 new jobs were created last month compared to an expected 155,000 and an unemployment rate which has been stable at about 4% for the past six months). Clearly, he feels damage to the economy is not being done at the current monetary policy settings.
Secondly, Powell and many others feel that President Trump will enact several inflationary policies and Powell wants to stay ahead of the game. All the time before Trump’s election, the Fed and most other central banks declared they are data dependent and not expectations dependent. It seems now they are trying to predict inflation from policies that have not yet been articulated in any formal sense – and then many would need to pass through Congress. They are switching from data dependency to expectations dependency without acknowledging it!
Trump talks about imposing lots of big import tariffs, repatriating lots of illegal immigrants, cutting taxes, reducing regulation, and cutting back government spending (among many other policies). Except for government spending, the major mooted policies could add to inflation.
Starting with tariffs, Trump has already walked back on his election campaign rhetoric. He recently said he will raise tariffs in small increments and not from ‘day one’. However, at the end of January, he said he would impose 25% tariffs on Canada and Mexico from February 1st. He is too inconsistent to try and second guess what will actually happen. No details are yet available and Trump has a history of making changes to his views without any real explanation.
We believe that many of his statements were just a vehicle for ‘bullying’ other countries into doing things that would benefit the US.
Take the case of repatriating some immigrants to Colombia near the end of January. Two US military aircraft (with illegals on board) were refused landing permission in Colombia so Trump slapped a large tariff on Colombia that day by executive order. The next day, Colombia capitulated and allowed the US to repatriate the deported Colombians – and Trump removed the tariff after only one day. No inflation consequences. A very big stick indeed.
The President of Mexico was reported to have said Mexico does not think the 25% tariff will come to pass. But even if tariffs are imposed, will they be on all goods and services and for how long?
While Trump has made some big inroads into stemming the flow of migrants into the US it is not obvious that he yet has a plan to remove those already settled in the country.
By executive order, Trump cut international aid. He failed in his attempt to freeze government grants and loans after a judge put a temporary pause on that executive order. He then withdrew the order but that doesn’t mean he won’t try again!
The opponents to Trump’s new immigration policy did not claim slowing down immigration at the borders would cause inflation – just the removal of current cheap labour. The number of illegal immigrants within the US was estimated by the State Department to be over 11 million in 2022. Since then, under Biden, there was a massive increase in immigration. Migration flows best serve a country when they are controlled and accommodated with long-term objectives in place.
There is a long way to go before a reasonable estimate of any inflationary pressure of Trumps putative policies can be estimated. In the meantime, modest cuts in rates by the Fed should go ahead which can be reversed if new obviously inflationary policies get enacted.
In Australia, some economic data look quite reasonable but a deeper dive reveals some major cracks. The latest jobs data looked strong with 56,300 new jobs created in December but that number includes a loss of 23,700 full-time jobs and a gain of 80,000 part-time jobs. The latest unemployment rate was 4.0%, from 3.9% in the prior month. These results are mixed at best.
Because our immigration rate has been high in recent times – resulting in a population growth over 2.5% p.a. – jobs need to be created to absorb the growing population. Jobs growth in aggregate does not signal a strong economy unless it is compared to population growth.
Recently, it was reported that a majority of the new jobs created in 2024 were in the National Disability Insurance Scheme (NDIS). While it might be laudable to create this service, it does not reflect the strength of the economy. These jobs are funded by the taxpayer and so reflect a fiscal stimulus and not an aggregate demand story. When the NDIS jobs reach their target, a serious deficiency in the demand for labour could be exposed.
In our latest round of data measuring inflation, all the key measures were within the RBA target band of 2% to 3% p.a. There is little argument for the RBA to not start cutting interest rates at its February meeting. The market has one interest rate cut priced in at 95% probability for this meeting and a better than a big chance (around 80%) of four cuts in total this year. That would still not get our rate down to as low as Canada’s or the European Central Bank’s (ECB) current rates – and our economy would be exposed to restrictive monetary policy while we are cutting.
Elsewhere in the world, Canada is in a per capita recession like us but the Bank of Canada (BoC) just cut for the sixth successive time to bring its rate down to 3% p.a. from 5% p.a. (before the interest rate cutting cycle started). Canada has endured six consecutive quarters of negative growth in per capita GDP – just like Australia!
The ECB just cut its interest rate by 25 bps to 2.75% p.a. In answer to a question at the media conference, the President of the ECB said they did not even discuss a 50 bps cut – even though the European Union (EU) growth was reported to be 0% in the latest quarter hours before the rate decision. Being so data dependent when the lags between policy change and the reaction in the economy are known to be ‘long and variable’ almost guarantees creating a recession – and then the central bank has to ease rates below the neutral rate to help the economy recover.
Japan has monetary policy moving in the opposite direction to most countries. The Bank of Japan (BoJ) had a negative interest rate for 16 years in its fight against deflation and low inflation. It has now increased its rate twice (to 0.5%) with an aim of achieving a 1% p.a. rate by the end of the year. Inflation had been too low for a very long time. Japan is hoping for modest inflation. The latest CPI inflation read was 3.6% p.a. when 3.4% p.a. had been expected! Stripping out volatile components to get the core rate, inflation came in on expectations at 3.0% p.a.
Asset Classes
The ASX 200 had strong capital gains in January (+4.6%) in spite of elevated market volatility. Presumably, much of the momentum is due to what investors think Trump might bring to markets and the heightened chance of several interest rate cuts by the RBA this year.
The Consumer Discretionary sector (+7.1%) and the Financials (+6.1%) sectors were the standout performers in January with only the Telco ( 1.5%) and Utilities ( 2.4%) sectors going backwards.
In the run up to the February reporting season, there has been a modest improvement in company earnings expectations (as surveyed by LSEG). We are now expecting a better than average capital gain in the ASX200 this year. The 4.6% gain in January does not put this index in anything more than a modest over-bought situation by our metrics.
International Equities
The S&P 500 also had a strong January (+2.7%) but there was much disruption towards the end of the month for two reasons. Firstly, ‘DeepSeek’, a China generative AI app was launched causing NVIDIA, the US GPU chip manufacturer, and several massive US tech companies, together with energy companies, to have their share prices slashed. Secondly, Trump stated on the last afternoon of January that he would introduce tariffs of 25% on each of Mexico and Canada – and 10% on China in a punitive move to address the illegal importation of fentanyl into the US.
The London FTSE (+6.1%) and German DAX (+9.2%) had particularly strong months but the Tokyo Nikkei ( 0.8%) and the Shanghai Composite ( 3.0%) went backwards. There were modest gains in Emerging Markets (+1.5%). The World index rose +3.5% in January.
The DeepSeek story is far too complicated for an Economic Update. However, based on technical advice, we believe the rout in US technology company share prices was overblown on the first day. A simple version of the argument is that DeepSeek is far more efficient than competitors like ChatGPT and Gemini so less (NVIDIA) GPU chips would be needed and, hence, the AI industry would be less of a drain on energy resources.
The claim that DeepSeek only cost US$6m to ‘train’ is misleading. CNBC argues the true cost of getting to launch was in excess of US$500m!
Importantly, the -16% fall in the Nvidia stock price on the day of the DeepSeek announcement did not cause an across-the-board fall. On that day, more stocks had gains than losses. A big sector rotation had started.
But this DeepSeek story misses a big point in Artificial Intelligence (AI) work. There is a ‘model training’ part which is very expensive to run as models consume as much data as they can from the web and elsewhere. Then there is the ‘model inference’ component that follows the research and development (R&D) ‘training’ component. We believe we have yet to scratch the surface of what the inference component will require in years, decades and maybe more to come. Perhaps a parallel can be drawn from the 1940s when the then Chairman of IBM conjectured there might be room in the world for five computers!
There are also reasonable uncertainties regarding the veracity of the DeepSeek claims, security concerns and censorship. We saw a report that said DeepSeek couldn’t answer the question, “Who is the President of China?” [due to censorship].
We still see the S&P 500 achieving a positive return this year. In the latest US quarterly reporting season there have been some very strong earnings reports and outlook statements. One notable exception was Telsa, which missed expectations on many fronts but the share price went up in after-hours trading and the next day. Was this possibly due to the blossoming connection between Trump and Musk?
The Fed seems to have successfully engineered a soft landing for the US economy. The 10-year US Treasurys’ yield is now just over 4.5% from below 2% at the end of 2021. The yield curve is no longer inverted (which occurs when the 10-year bond yield is below the 2-year bond yield).
The RBA has yet to start cutting its overnight cash rate (OCR) but we expect the easing cycle to start in February 2025 and the RBA reduce the OCR from its current 4.35% p.a. by 0.25% to 4.10% p.a. with the prospect of more interest rate cuts to follow. Seldom does a central bank cut or raise interest rates only once in a cycle.
The BoJ just hiked for the second time in this cycle – to 0.5% – with the aim of a 1% p.a. interest rate by year end.
The UK is in danger of creating a serious recession not just because of interest rate policies but because it is introducing some sharp tax increases. The BoE was on hold at 4.75% p.a. at its December meeting.
The Bank of Canada (BoC) has just made its sixth interest rate cut in the current easing cycle – down to 3% p.a. from 5% p.a.
The ECB needs to cut rates further from the current 2.75% p.a. as the German economy – the powerhouse of the EU economy – has just posted its second year of negative GDP growth ( 0.2% in 2023 followed by 0.3% in 2024) and EU growth was 0% in the latest quarter.
Many central banks held rates too high for too long in their quest to be “data dependent”. Only the US seems to have dodged that bullet and possibly because – at least in part – of former President Biden’s Inflation Reduction Act producing strong fiscal stimulus.
Other Assets
Brent Crude Oil (+3.2%) and West Texas Intermediate (WTI) Crude Oil (+1.1%) prices were up in January. The future of oil prices is clouded by any impact from Trump’s policies. He wants the Saudis to increase supply to reduce oil prices. In turn that would hurt the Russians and, potentially contribute to an end to lead to the war in the Ukraine.
Secondly, one of Trump’s new mantras (energy policy) is ‘Drill baby drill’. He is overturning much of Biden’s green energy push and wants fossil fuels to support the economy more until green energy can reasonably do its job.
If Trump is successful, oil prices could fall from current levels which, in turn, would lower headline rates of inflation.
Of course, if the Saudis bring down oil prices too much, there will be less incentive to “Drill, baby, drill”.
The price of gold also rose strongly (+7.0%) in January.
The prices of copper (+4.1%) and iron ore (+4.4%) were also up strongly in January with the price of iron ore closing out the month at $US105 per tonne after dipping to $US96.76 during January.
The VIX share market ‘fear’ index came down from its intra-month high of 19.5 to close the month at 16.4. We think of the normal range being around 12 to 14.
The Australian dollar (AUD) was largely flat (+0.1%) over January. If the Fed does slow down interest rate cutting, but the RBA becomes active in cutting interest rates, some further weakness might be seen in the AUD.
Regional Review
Australia is marching towards a general election – not yet called – and it is unclear at this stage what the protagonists are plotting in any detail for their campaigns.
Jobs data were mixed but, importantly, jobs growth has been reportedly dominated an expansion of NDIS jobs such that most of employment growth in the last year was due to NDIS. While this might be a great source of work for the employees and a source of benefit for the recipients, the jobs are funded by the taxpayer. While these jobs are genuine, they are not an indicator of the strength of the economy but simply from fiscal stimulus. The RBA encouraged to factor this component into its calculations when discussing the need for interest rate cuts.
Retail sales enjoyed a welcome bounce in the latest data. Sales were up 3% in dollar terms and 0.5% after an inflation adjustment. That’s not greater than population growth so we are all (on average) buying less ‘things’ than last year but, at least, ‘real’ sales did not go backwards as they have in recent history.
China
The China story for January was overshadowed by the launch of the ‘DeepSeek’ AI software. NVIDIA, the biggest company in the S&P 500 had its price fall about 16% on the news. Lots of ‘Mag 7’ stocks fell a few percent with it as did lots of energy stocks.
As one broker wrote, China may have taken out lots of put options over the Nvidia share price. There is no doubt Trump and China’s President Xi are going toe to toe. Trump has so far changed from saying he would place a 60% tariff from ‘day one’ on China to a 10% tariff from 1 February 2025 – less than on Mexico and Canada!
But the good news (if it wasn’t generated by DeepSeek!) was that China Q4 GDP growth came in at 5.4% making 5% for the year – maybe a coincidence but exactly what the government’s policy target was. The last four quarters’ results were 5.3% p.a., 4.7% p.a., 4.6% p.a., and 5.4% p.a.. Looks like a bottom in Q3 when the big stimulus package was launched.
US
The nonfarm payrolls (jobs) data came in at 256,000 against an expectation of 155,000 with the unemployment rate at 4.1% and below the expected 4.2%. Wage growth was 3.7% which is not high enough to upset price inflation forecasts.
The initial reaction to the jobs report on Wall Street was negative because investors feared no more interest rate cuts – or even a rate hike! The inflation data that followed soothed market nerves.
CPI-excluding-shelter inflation is well under control and inside the 2% p.a. Fed target.
The preliminary estimate of December quarter GDP growth was 2.3% p.a. against an expected 2.5% p.a. The final estimate for the September quarter was 3.1% p.a. GDP growth for 2024 was 2.8% p.a. following 2.9% p.a. in 2023. Consumer spending rose by a very robust 4.2% in the December quarter.
Europe
The ECB cut its interest rate to 2.75% p.a. and EU growth was flat in the latest quarter. EU inflation rose for the third consecutive month to 2.4% p.a. having previously been below the target of 2% p.a. Further interest rate cuts are expected this year. The rise in inflation has been attributed to energy prices no longer falling and cancelling positive inflation in other goods and services.
Germany posted its second consecutive year of negative GDP growth: 0.2% in 2023 and 0.3% in 2024.
The UK is reportedly facing a recession as new taxes are introduced.
Rest of the world
Colombia has accepted some of its citizens who were deported from the US.
Slow progress has been made on a cease-fire and hostage exchange in the Israel-Gaza conflict.
Trump is calling on the Saudis to cut oil prices to increase financial pressure on Russia with the hope that it may help end the war in the Ukraine.