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The lockdown in Victoria serves as a potent reminder that Covid-19 can affect the domestic economy unexpectedly at any time, at least until a large proportion of the Australian population is vaccinated. The recent economic recovery has been gathering pace, leading to favourable outcomes in the labour market in particular. Nonetheless, there remains significant slack in the economy, and CPI inflation equals a mere 1.1% (year-on-year, Q1 of 2021), well below the RBA’s official target band of 2-3%. The RBA Shadow Board is convinced that the cash rate should remain at the historically low rate of 0.1% for at least another year. It confidently expects that the cash rate will need to be higher than its current level in three years from now.
The most recent readings of the Australian labour market surprised analysts yet again. The official ABS unemployment rate dropped from 5.6% in March to 5.5% in April. However, total employment unexpectedly declined by just over 30,000, while the labour force participation rate also dropped, from 66.3% to 66%. Encouragingly, the youth unemployment rate fell by another full percentage point, for the third consecutive month, to 10.6%. The labour market will have to tighten considerably more before there is any major upward pressure on wages.
The Aussie dollar moved little in May, oscillating mostly within the 77-78 US¢ range. Yields on Australian 10-year government bonds dropped a little, to just above 1.6%. The shapes of the yield curves barely shifted: the yield curve in short-term maturities (2-year versus 1-year) remains 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 continue to display normal convexity. The spread between the 10-year rate and the 2-year rate narrowed slightly, to 157 basis points. The Australian stock market continued its sustained ascent, posting a new all-time high at the end of the month: the S&P/ASX 200 stock index closed on 28 May just shy of 7,200.
The new federal budget reflects the overall strength of the Australian economy, pouring an additional $104 billion into Treasury’s coffers between now and 2024-25, relative to the official forecasts released six months ago. This means that, after taking all new spending into account, the underlying deficit is projected to equal $161 billion in 2020-21, $37 billion less than assumed in last December’s Mid-Year Economic and Fiscal Outlook. However, further fiscal and monetary stimulus is needed for the foreseeable future and so large budget deficits and low interest rates are likely to persist for years.
By international comparison, the vaccine rollout in Australia is painfully slow. This is economically inefficient as widespread immunity is a prerequisite for an economy without lockdowns and without closed international borders. Prime Minister Scott Morrison’s announcement that the government is unlikely to start re-opening borders before mid-2022 is a worrying sign of costly insularity.
Globally, economic fortunes ride heavily on vaccination rates. The US and Europe, due to their vigorous vaccination campaigns, coupled with more favourable seasonal conditions, are likely to rebound strongly. S&P Global revised its growth forecast for 2021 for the US from 4.2% to 6.5%, and the European Commission revised its growth forecast for the euro area economy up to 4.3%. The economies of other parts of the world – India, Latin America and parts of Africa – will continue to struggle until the pandemic is contained.
Australian consumer confidence remains high but retreated somewhat from the previous months high, as seen in the drop of the Melbourne Institute and Westpac Bank Consumer Sentiment Index from 119 to 113. Retail sales (month-on-month) expanded by 1.1% in April. NAB’s index of business confidence jumped from 17 to 26 in April. Other business indicators also point up: the manufacturing and services PMIs increased from 59.9 to 61.7 and from 58.7 to 61 in April, respectively. Importantly, and encouragingly, capacity utilisation increased for the eighth successive month, jumping nearly 3 percentage points in April, to 85.26%, the highest it has been in 25 years. House prices across Australia experienced another month of growth, averaging 1.8% month-on-month for the country’s five largest capital cities. The AI Group/HIA Australian Performance of Construction Index declined 2.7 points to 59.1 from a record high in the previous month.
For seven months, the official cash rate target has been at the unprecedented level of 0.1%. The Shadow Board’s conviction to keep the overnight interest at 0.1% eased slightly but remains very strong. The Board attaches a 95% probability that the overnight interest rate should remain steady (98% in May), a 5% probability that an increase is appropriate (2% in May) and a 0% probability that a further rate cut to below 0.1% is appropriate.
The probabilities at longer horizons are as follows: 6 months out, the confidence that the cash rate should remain at 0.1% equals 78% (80% in May), the probability attached to the appropriateness for an interest rate decrease is exactly 0%, while the probability attached to a required increase increased slightly from 19% to 22%. One year out, the Shadow Board members’ confidence that the cash rate should be held steady equals 62% (64% in May). The confidence in a required cash rate decrease, to below 0.1%, is 0% (down from 1% in May) and in a required cash rate increase 38% (35% in May). Three years out, the Shadow Board attaches a 11% (9% in May) probability that the overnight rate should equal 0.1%, a 0% probability that a rate lower than 0.1% is appropriate, and a 89% (91% in May) probability that a rate higher than 0.1% is optimal. The range of the probability distributions over the 6 month and 12 month horizons widened to 0-2%, 75bp wider than in the previous month, and the range of the probability distribution for the 3-year recommendation is unchanged, extending from 0% to 2.5%.
The data released this month has broadly confirmed my view of the recovery. The easy wins from re-opening have largely been exhausted, and so growth momentum is now slowing to a more normal, sustainable pace. It looks as though the end of JobKeeper has not had a significant impact at the macro level and the outlook is still generally positive – I expect the economy will expand by over 4% this calendar year.
But challenges and risks remain. The latest Melbourne lockdown and spike in cases in other Asian economies that were previously successfully controlling COVID-19 highlights that until the majority of the population are vaccinated the risk of an outbreak and tighter restrictions remain. And it will not be possible for the economy to fully recover until all restrictions are removed. The labour market data is now starting to confirm the expected patchy nature of the recovery; NSW and VIC, who are most exposed to international tourism and higher education, are yet to return to pre-COVID employment levels while QLD and WA have moved significantly beyond this.
This macro observation aligns with survey data and other micro indicators that are flagging labour shortages in specific regions and sectors. How well the economy is able to shift resources to the states where demand is strongest, and away from the regions where it is relatively weak, will be a key determinant of the economy’s performance going forward.
Given this remaining risks and challenges, and the need for a broad-based recovery to be well-entrenched to anchor inflation expectations and outcomes within the 2-3% target band, it is right for the RBA to hold its current settings through the rest of this year.
The RBA Board’s agreement at the May meeting to consider in the July meeting whether or not to retain the April 2024 bond as the target bond for 3-year yield-control target (hence suggesting when liftoff of the OCR might occur) or shift to the next maturity (the November 2024 bond, which would imply a six-month delay in liftoff for the OCR) is a welcome development. This provides a clear communication of how the yield-curve control measure could be adjusted in reaction to changes in expectations about future economic conditions. If the forecasts for inflation and inflation expectations move comfortably into the 2-3% target range by the July meeting, the RBA can signal liftoff could occur around April 2024. If they remain below, the RBA should move to the next bond issue and leave open the possibility of a further shift to a later maturity.
I suspect the forecasts for inflation will still not be strong enough by the July meeting and the discussion about which maturity to target will shift six months later. This is especially the case as “comfortably with the 2-3% target range” should be in the top half of the range to help partially offset the effects of the Covid crisis (and past misses of the target range) on the price level.
Updated: 1 August 2021/Responsible Officer: Crawford Engagement/Page Contact: CAMA admin
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