the next market recovery depends on it

The first is that non-bank and bank financing costs have increased significantly, and lenders can pass these costs on to customers through higher borrowing rates. This could do some of the heavy lifting for the RBA.

A second consideration is the increased sensitivity of household balance sheets to changes in interest rates, implying that the RBA may not have to raise rates as far as it has in the past. During the week, RBA Deputy Governor Luci Ellis has been at pains to point out that Martin Place cannot be confident about where the true “neutral” exchange rate is, despite suggestions that it is. would lead directly to 2.5%.

A similar debate is playing out in US markets, where equities and fixed rate bonds (or interest rate duration) are rallying in correlated unison, despite post-GFC momentum where duration tended to be negatively correlated to stocks.

After dropping almost 20% from peak to peak, the S&The P 500 index rebounded 6.7%. At the same time, the yield on 10-year US government bonds fell from a recent high of 3.20% to just 2.76%, meaning bond prices rose.

U.S. investors are now hoping the Fed will only raise rates to its own “neutral” estimate of around 2.8%, avoiding having to tighten policy to a point that would tip the economy into recession. This is based on the assumption that underlying inflation is abating.

While core CPI month-over-month inflation remained stubbornly elevated at 0.6% in April, the Fed’s preferred measure (the core PCE index) is expected to post a benign rate of 0.3% Friday evening. This would represent the third consecutive month of core PCE inflation of 0.3%, which is canceling out at a much more acceptable level of 3.6%.

It would also mean that the PCE’s core year-over-year inflation rate fell from its peak of 5.3% to 4.9% or lower, paving the way for a recovery in risk based on the belief that the world’s most important central bank engineer a soft landing.

The alternative is an upside surprise with core PCE inflation of 0.4-0.5%, signaling an annual pace of 5% or more. This would raise concerns that the Fed would have to adopt restrictive and crushing aggregate demand enough to push the US economy into recession in 2023.

Using stock and bond market data, our modeling suggests this is a very plausible scenario. Our analysis also highlights that S&Earnings for the P 500 are extremely high relative to their historical trend, with a real risk of further sharp declines in the shares as earnings average back. This will be amplified if the Fed has to adopt a restrictive policy.

Subject to the question of where the RBA is taking interest rates, Australia is likely to remain the “wonder” under the watchful eye of a cheap Australian dollar, high commodity prices, robust consumer spending, a resurgence of business investment and a rebound in unskilled and skilled migration.

Skill of work

However, the road ahead remains complex for our new federal government, led by Prime Minister Anthony Albanese. At the margin, markets are expecting more stimulus from new Treasurer Jim Chalmers compared to the counterfactual, which could mean the RBA has more wood to cut.

Labor is endowed with an exceptional economic talent, which it should exploit. The best economic brain in parliament is unambiguously Dr. Andrew Leigh, a famous Harvard doctor who was a professor of economics at ANU. Labor would be mad not to take advantage of his world-class capabilities, which have focused on innovative, empirically tested policy ideas.

Chalmers also has access to Yale Ph.D. Daniel Mulino, who has spent much of his career providing valuable economic advice. And then there’s ambitious new Paramatta member Andrew Charlton, who earned a PhD at Oxford and played a crucial role in the Rudd government’s response to the global financial crisis. This included crafting unprecedented policy measures, such as the purchase of more than $10 billion in residential mortgage-backed securities during the crisis, which rescued many small bank and non-bank lenders while making a return for taxpayers.

Leigh, Mulino and Charlton could play an important role in bolstering what is otherwise a meager parliamentary bench.

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