Outcome
The inflation surge beginning in 2021 was caused by many economies’ excessively loose monetary and fiscal policies. On top of the disruption to production networks from the covid pandemic and shutdowns, a positive demand shock met a negative supply shock. The global excess demand led to a worldwide inflation increase with differences in inflation outcomes across economies that were either larger or smaller than the dominant worldwide inflation factor. The Russian invasion of Ukraine in February 2022 added additional energy and commodity price shocks on top of the macroeconomic imbalances in the global economy.
Inflation has persisted even though some initial factors driving inflation, such as energy and commodity price increases, have almost returned to pre-shock levels. Recent data from the Institute of International Finance ( and also noted in the World Bank Global Economic Prospects report (June 2023) show that PMI delivery times have fallen below pre-pandemic levels, and the higher markups that firms have received during the inflation surge are dropping quickly. The supply shocks from Covid and The Ukraine war may have already self-corrected. There is a reasonable chance that while central banks are trying to reduce excess demand through higher interest rates, the policy will have its impact when inflation is already falling due to supply-side adjustments. The dynamic of supply and demand adjustment suggests a significant probability of an overshoot of the deflationary impulses now passing through the global economy. The latest Australian monthly inflation data is consistent with this dynamic.
My assessment of monetary policy is unchanged from June.
The most important information relating to monetary policy from the past few months was the RBA’s modelling of alternative interest rate paths, released under Freedom of Information. This indicated that large front-loaded increases in the cash rate, quickly taking it to 4.8 percent, would minimise a quadratic loss function with the inflation and unemployment gaps as arguments.
Foreign central banks appear to be raising their policy rates quickly for this reason.
Disagreements with this analysis are unconvincing.
The RBA leadership appears to prefer a more gradual increase in the unemployment rate. However, this runs the risk of a de-anchoring of expectations and accelerating inflation. As the RBA has argued, that will involve even higher unemployment in future.
The RBA’s preferred path seems to reflect aversion to action; it would prefer to make errors of omission than errors of commission, because it gets publicly blamed for the latter.
Others oppose higher rates because they hope that the NAIRU is well below common estimates. If there was any econometric work underpinning these hopes I would take them seriously. Instead, they seem to reflect wishful thinking and a disregard of past experience. Central banks have tried to “test” below-NAIRU unemployment rates before (for example, the RBA in 2007) and the result was rapid acceleration in prices and wages.
Updated: 14 May 2024/Responsible Officer: Crawford Engagement/Page Contact: CAMA admin
Yet Again: Shadow Board Recommends 25 bps Rise, to 4.35 Percent
Encouragingly, Australia’s monthly consumer price index (CPI) inflation dropped from 6.8% in the twelve months to April, to 5.6% in May, bringing the inflation rate closer to the RBA’s target band of 2-3%. The biggest contributors to inflation were, once again, housing (+8.4%), followed by food and non-alcoholic beverages (+7.9%). Automotive fuel prices, on the other hand, fell by 8.0%. The official, seasonally adjusted unemployment rate dropped by 0.1 percentage points, to 3.6%, on the back of strong employment growth. Consumer sentiment improved marginally, while business sentiment, on balance, softened slightly. Yet again, the RBA Shadow Board believes a further rate rise of 25 basis points, to 4.35%, is needed to avoid high inflation becoming entrenched. In particular, it attaches a 56% probability that the overnight rate should be higher than the current level of 4.10% and a 39% probability that “no change” this round is the appropriate policy.
The official Australian seasonally adjusted unemployment rate fell 0.1 percentage points in May, from 3.7%, to 3.6%, on the back of a total employment change of more than 75,000. The labour force participation rate increased to 66.9%, a historical all-time high. The youth unemployment rate dropped to 7.6%, but the underemployment rate increased to 6.4%. Also in seasonally adjusted terms, total monthly hours worked in all jobs fell by 36m, or 1.8%. There is no new, recent data on wages, which the RBA is, of course, looking at closely as a possible sign that inflation expectations are becoming entrenched.
The Australian dollar continued its sideways movement throughout the month of June, ending the month just above 66 US¢. Yields on Australian 10-year government bonds rose in concert with last month’s increase in the overnight rate, pushing them just above 4%. All yield curves, between short-/medium and 10-year bonds, remain inverted. Australian shares, too, remained range-bound; the S&P/ASX 200 stock index closing the month some 100 points higher than at the end of May, just above 7,200.
The Melbourne Institute and Westpac Bank Consumer Sentiment Index unexpectedly improved by 0.2% month-over-month in June 2023, to 79.2. Retail sales in May increased too, by 0.7% month-over-month, the fastest increase in retail trade this year. In the same period, private sector credit growth, and housing credit growth specifically, eased from 0.6% month-on-month to 0.4% and from 0.4% to 0.3%, respectively. NAB’s index of business confidence, returned into negative territory (-4) in May, after a neutral reading in April, with nearly all industries affected. The Judo Bank Australia Composite PMI and Services Sentiment indicator fell for a second month, from 51.6 to 50.5, and from 52.1 to 50.7, respectively. The capacity utilisation rate fell in May from 85.11% to 84.67%. Both the Composite Leading Indicator and the Westpac-Melbourne Institute Leading Indicator indices basically remained flat. Although monthly sentiment data is notoriously noisy, the readings from the past few months do suggest that business confidence is softening, pointing to a possible slowdown in economic activity.
The world economy remains on a knife-edge, with several European economies slowing down significantly and recession in the US still a possible scenario. China’s post-Covid rebound has also lost steam. Attention of global risks is slowly turning away from the familiar factors that sparked inflation (disrupted supply chains and high energy prices) to demand-side factors (in particular, the large Covid-induced fiscal stimuli) and slow productivity growth. Gita Gopinath, the International Monetary Fund’s First Deputy Managing Director, in a recent speech pointed to the possible risks of geoeconomic fragmentation, which would have lasting consequences for the world economy and global productivity. There are also continuing risks associated with wealth and income inequality and financial imbalances.
For the current (July) round, the Shadow Board believes that, on balance, the overnight rate should rise again: it is attaching a 39% probability that pausing the tightening cycle is the appropriate policy and a 56% probability that another rate rise, above the current level of 4.10%, is the appropriate policy stance, with a mode recommendation of a 25 bps increase to 4.35%. The probability attached to a required rate reduction equals 6%.
The probabilities at longer horizons have widened slightly: 6 months out, the confidence that the cash rate should remain at the current setting of 4.10% equals 15%; the probability attached to the appropriateness of an interest rate decrease equals 26%, while the probability attached to a required increase equals 59%. The mode recommendation at this horizon is 50 bps higher than for the current recommendation, that is, 4.85%.
One year out, the Shadow Board members’ confidence that the appropriate cash rate should remain at the current level of 4.10%, equals 14%. The confidence in a required cash rate decrease, to below 4.10% equals 43%, and its confidence in a required cash rate increase, to above 4.10%, is 43%. Three years out, the Shadow Board attaches a 10% probability that the overnight rate should equal 4.10%, a 73% probability that a lower overnight rate is optimal and a 17% probability that a rate higher than 4.10% is optimal.
The range of the probability distribution for the current recommendation expanded by 25 bps, extending from 3.60% to 4.85% (compared to a range of 3.60% to 4.60% in the previous round). For the 6-month horizon it extends from 3.35% to 5.85% (unchanged). The range for the 12-month horizon, at 1.10%-6.10%, narrowed by 25bps, and likewise for the range of the 3-year horizon, which extends from 1.10%-5.1%.