AUD/USD

U.S. retail sales rebounded sharply in October as purchases of motor vehicles and building materials surged, but data for the prior two months was revised lower and the underlying trend suggested that consumer spending was probably slowing down.

Still, the report on Thursday from the Commerce Department showed broad gains in sales ahead of the holiday shopping season, which bodes well for consumer spending and the overall economy as the fourth quarter gets under way.

Retail sales increased 0.8% last month. Retail sales in September slipped 0.1% instead of rising 0.1% and sales in August were also weaker than previously thought.

The market had forecast retail sales increasing 0.5% in October. Sales rose 4.6% from a year ago.

Excluding automobiles, gasoline, building materials and food services, retail sales increased 0.3% last month. These so-called core retail sales correspond most closely with the consumer spending component of gross domestic product.

Data for September was revised lower to show core retail sales rising 0.3% instead of gaining 0.5% as previously reported. Core retail sales fell 0.2% in August rather than being unchanged.

Strong domestic demand and a tightening labor market support views that the Federal Reserve will increase interest rates in December for the fourth time this year. The U.S. central bank last Thursday kept rates unchanged, but said data "indicates that the labor market has continued to strengthen and that economic activity has been rising at a strong rate."

The Reserve Bank of Australia ended its November board meeting with rates held at an all-time low of 1.50%, and signalled policy will stay there for a while yet.

"Inflation remains low and stable," RBA Governor Philip Lowe said in a statement. "Inflation is expected to pick up over the next couple of years, with the pick-up likely to be gradual."

"Gradual" remains the watchword as inflation stays stubbornly below the central bank's 2-3% target band and wages only barely keep up with consumer prices despite solid job gains.

The bank will issue updated economic forecasts this Friday and Lowe offered a taster on the outlook, noting that inflation would slightly pick up to 2.25% in 2019 and a "bit higher" the following year.

"With the economy growing above trend, a further reduction in the unemployment rate is expected to around 4.75% in 2020," Lowe said.

That is a marked improvement from the previous central bank forecast of 5.25% for mid-2020 in projections released in August. Tuesday's revised forecast follows an unexpected slip in the unemployment rate to 5.0% in September, led by a bumper run in job growth over the past year and as fewer people looked for work.

Financial markets have steadily pushed out the likely timing of a move, with the most distant futures contract for April 2020 pricing in about 80% change of tightening.

The domestic case for a hike has also been weakened by a sharp slowdown in the once red-hot housing market in Sydney and Melbourne.

Values in Sydney, the country's largest city, clocked their worst annual performance since 1990 in October, led by a regulatory clamp-down on investment loans and tighter lending standards by banks.

So far, Lowe hasn't displayed any unease over this downtrend, saying there is still "strong competition for borrowers of high credit quality."

Lowe remained upbeat about the economy and said in recent comments that the next move in rates is likely to be up rather than down.

Next week, the Federal Reserve will end its seventh regular FOMC meeting of the year. It is widely expected that the committee will keep the target range for the federal funds rate at an unchanged 2.00% to 2.25%, while reiterating the outlook for another 25bp move in December. Newly appointed Vice Chair Richard Clarida said as recently as last Thursday, i.e. right before the start of the blackout period, that “even after our most recent policy decision to raise the range for the federal funds rate by 0.25 percentage point, monetary policy remains accommodative, and I believe some further gradual adjustment in the policy rate range will likely be appropriate.” Moreover, he added that “with the economy now operating at or close to mandate-consistent levels for inflation and unemployment, the risks that monetary policy must balance are now more symmetric and less skewed to the downside.” Neither the recent stock market volatility nor President Trump’s repeated comments have thus affected the Fed’s underlying policy view. This should be indicated by the statement reiterating its main policy outlook: “The Committee expects that further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2% objective over the medium term. Risks to the economic outlook appear roughly balanced.”

Rather than making any immediate policy changes, the Fed will likely use the meeting to discuss the size and composition its balance sheet should have after the normalization is completed. According to the minutes of the August 1 FOMC meeting, Fed Chair Jerome Powell suggested that such a discussion of operating frameworks would likely resume in the fall. Previously, the committee had said that it wanted the smallest balance sheet that is consistent with a good monetary policy. At some point, that general statement will need to be translated into a target size for excess reserves; we expect a ballpark range of USD 500 bn to USD 750 bn, compared to the current level of USD 1.7 tn and a maximum level of USD 2.7 tn, which was hit in 2014. With regard to the composition, the Fed has suggested before that it ultimately targets a Treasury-only balance sheet, which means that all MBS and agency debt holdings would be wound down. This is likely to be confirmed. A circumstance that is adding some urgency to the topic is the fact that the effective fed funds rate continues to push against the interest paid on excess reserves. Unless the situation changes by the December meeting, it seems likely that the Fed will once again raise the interest paid on excess reserves by less than the target range in order to push the effective fed funds rate back to the middle of the band.

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