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Apart from some isolated hotspots, Australia’s policy of containing the coronavirus remains very successful, certainly by international comparison, and the economy should continue to reap the benefits of this normalisation. The inflation rate ticked up in the December quarter, from 0.7% year-on-year to 0.9%, based on the latest ABS CPI estimate, but remains well below the RBA’s official target band of 2-3%. In spite of recent improvements in economic data, the RBA Shadow Board’s conviction that the cash rate should remain at the historically low rate of 0.1% is strengthening further. The Board attaches an 89% probability that this is the appropriate interest rate setting, while it attaches an 11% probability that a rate hike is appropriate and a 0% probability that a rate cut to below 0.1% is appropriate.
Labour market data since the end of Victoria’s 100-day Covid-19 lockdown has been positive. The official ABS unemployment rate peaked in October at 7% and has fallen in the two subsequent months to 6.6%. Overall employment rose by 50,000 in December, the majority of which is full-time. Youth unemployment also fell, from 15.6% to 13.9%, job advertisements are up and the labour force participation rate edged up to 66.2%. So far, the unwinding of Jobkeeper assistance has not appeared to hurt the labour market, a reflection of the relative strength of the Australian economy and the success in containing the Covid-19 pandemic.
The Aussie dollar continued its climb into the new year, reaching a high of nearly 78 US¢ but retreating slightly since then. Yields on Australian 10-year government bonds also rose, in tandem with the macroeconomic rebound, from around 0.90% in late November to 1.13% in late January. While the yield curve in short-term maturities (2-year versus 1-year) is flat, as desired by the Reserve Bank of Australia, in mid-term versus short-term maturities (5-year versus 2-year) and in higher-term maturities (10-year versus 2-year) the yield curves show normal convexity. The big rebound in the stock market at the beginning of the fourth quarter 2020, paused for the time being. Relative to two months ago, the S&P/ASX 200 stock index is virtually unchanged at just above 6,600.
The second (in some cases third) Covid-19 wave has the world firmly in its grip. Even China has witnessed a resurgence of infection rates. The approval of various vaccines marks an important step in the battle against Covid-19, but supply constraints, poor management and nationalistic policies are hampering the rollout. Australia – understandably, given the low case numbers – is in no great hurry to vaccinate its population.
Since the last interest rate round Joe Biden has assumed the US presidency and enacted a flurry of presidential decrees in an attempt to undo many of his predecessor’s policies. Many of these, whether in relation to foreign policy or to climate change action, will also affect Australia’s policy choices. Geopolitical tensions remain in place and are unlikely to be resolved soon. For Australia this remains a serious concern as diplomatic relations with China, its main trading partner, are strained.
Consumer confidence is roughly where it was two months ago, after a brief surge in December: the Melbourne Institute and Westpac Bank Consumer Sentiment Index currently stands at 107, compared to the historic low of 76 in April 2020. Retail sales remain volatile, having increased by 7.1% month-on-month in November and contracted by 4.2% month-on-month in December. Private sector credit increased by 0.3% month-on-month, the most since March 2020, buoyed by housing credit and business credit growth.
Business indicators experienced a dent in December, presumably reflecting the Covid-19 flare-up in NSW. NAB’s index of business confidence dropped from 13 to 4, however business conditions improved from 7 to 14, the highest since September 2018. The manufacturing PMI fell slightly in November, while the services PMI rose modestly in the same period. Capacity utilisation tightened noticeably, from 77.93% in October to 79.32% in November.
The housing market continues to surprise with its persistent strength. House prices continue to climb virtually everywhere, with regional house prices experiencing the largest gains. New home sales jumped a whopping 92% month-on-month in December, the second-highest growth rate in 20 years. There are likely multiple reasons for this, including the HomeBuilder program, record-low interest rates, and a shift in demand towards detached houses. The AI Group/HIA Australian Performance of Construction Index climbed again, from 52.7 points in October to 55.3 in November, five points short of the all-time high recorded in 2017. Many analysts expect the housing market to remain strong in the medium-run. Some shadow board members have made it clear that the appropriate policy lever to reign in house prices is through macroprudential policies, not the overnight interest rate.
Starting with the October round, Shadow Board members were given the option to attach probabilities to interest rates in increments of 5 basis points, instead of 25. This generates significantly more granular distributions. In November the Reserve Bank of Australia reduced the official cash rate target to the unprecedented level of 0.1%. The Shadow Board now overwhelmingly recommends keeping the overnight rate on hold at this level. In particular, the Shadow Board attaches an 89% probability that the overnight interest rate should remain at 0.1% (87% in December). It attaches a 0% probability that a further rate cut to below 0.1% is appropriate (unchanged from the previous round) and an 11% probability that a rate higher than 0.1% is appropriate (13% in December).
The probabilities at longer horizons are as follows: 6 months out, the confidence that the cash rate should remain at 0.1% equals 65% (55% in December), the probability attached to the appropriateness for an interest rate decrease, equals 2% (3% in December), while the probability attached to a required increase is 33% (43% in December). One year out, the Shadow Board members’ confidence that the cash rate should be held steady equals 51% (43% in December). The confidence in a required cash rate decrease, to below 0.1%, is 1% (2% in December) and in a required cash rate increase 48% (55% in December). Three years out, the Shadow Board attaches a 24% probability that the overnight rate should equal 0.1% (34% in December), a 1% probability that a rate lower than 0.1% is appropriate (unchanged from December), and a 75% probability that a rate higher than 0.1% is optimal (67% in December). The range of the probability distributions over the 6 month and 12 month horizons spans from 0% to 1.0%, the range of the probability distribution for the 3-year recommendation is wider, extending from 0% to 2.5%.
The economy has rebounded through the initial phase of recovery more quickly than I was expecting, and given the latest data I don’t think any additional monetary support (either negative interest rates or a further expansion of QE) is needed.Moving forward from here, the pace of recovery will naturally slow but beyond this, the economy will need to go through a period of structural change as the more permanent impacts of the pandemic materialise. It’s clear that international travel and with it migration flows (and potentially domestic travel, given the risk of further domestic outbreaks and the response of states to these) will not return to pre-pandemic levels for some time yet, and these sectors are unlikely to return to the growth trajectory they were tracking prior to COVID. Given this I expect a full recovery from COVID, which takes the economy back to full employment, will take some time and until then a highly accommodative monetary policy stance will be appropriate.
It will be important for the RBA to focus on bringing various measures of inflation expectations back up into the 2-3% target range and not be distracted by calls to use contractionary monetary policy to address movements in house prices (some of which may reflect an increased likelihood of at least partial work-from-home in many sectors and less travel even beyond the Covid crisis) or to worry too much about transitory (rather than sustained) movements in measured inflation. Given this, a continued commitment to maintain low interest rates until inflation and inflation expectations remain persistently within the target range and noting that this timeframe is expected to be at least 3 years is highly appropriate. It is worth noting that break-even inflation for United States has recently returned back above 2%, so it should be possible that this will happen for Australia too given clear and deliberate policy communications.
Updated: 1 March 2021/Responsible Officer: Crawford Engagement/Page Contact: CAMA admin
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