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There remains considerable slack in the Australian economy, as seen by low utilisation rates, relatively high underemployment and a low participation rate, but there are also positive signs, reflected in improved retail sales and producer sentiment. With the two most populous states coming out of lockdown and most states experiencing very high vaccination rates, there is good reason to believe production will pick up significantly in the fourth quarter of 2021 and beyond. This outlook is bolstered further by the removal of international border restrictions and of quarantine requirements for vaccinated travellers. The annual inflation rate in Australia, measured by the growth rate of the CPI, fell from 3.8% to 3% (year-on-year) in the third quarter of 2021, putting it right at the top of the RBA’s official target band of 2-3%, whereas the preferred inflation statistic, the trimmed mean measure of core inflation, rose to 2.1%, comfortably at the bottom of the target range. The RBA Shadow Board’s verdict is unchanged from the previous month: it is certain (100% confident) that keeping the cash rate at the historically low rate of 0.1% is the appropriate policy for the November round.
As widely expected, the most recent official ABS unemployment rate increased, albeit by a small amount, from 4.5% in August to 4.6% in September. As argued in previous months, this figure should not be taken in isolation as a barometer for the overall health of the labour market as total employment contracted massively for another month, this time by nearly 138,000. Correspondingly, the participation rate dropped further, to 64.5%, whereas the underemployment rate fell slightly to 9.2%. Monthly hours worked increased 15 million hours, that is, by 0.9%. Job advertisements declined for the third month in a row.
The Aussie dollar, after falling to a low of 72 US¢, rallied to close the month of October above 75 US¢. Yields on Australian 10-year government bonds continued their ascent, from approx. 1.5% to 2%. The shapes of the yield curves have correspondingly steepened: the yield curve in short-term maturities (2-year versus 1-year) is now showing some convexity, with a spread of 32 basis points, contrary to what the RBA is intending; 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, although the spread between the 10-year rate and the 2-year rate narrowed slightly, from 146 basis points a month ago to 137 basis points at the end of October. The Australian stock market pared some of its recent losses, ending up higher than in the previous month; the S&P/ASX 200 stock index closed above 7,350.
There are grounds for cautious optimism about the global economy, as more and more countries, are putting the Covid-19 pandemic, and the associated restrictions, behind themselves. However, some concerns remain. These include flagging vaccination rates in several advanced economies as well as slow vaccination campaigns in numerous developing countries; a noticeable uptick in global inflation, which are primarily due to higher commodity prices and global supply bottlenecks and thus should be transitory; and geopolitical tensions that continue in the background. Furthermore, recent data on the US economy have disappointed somewhat and questions remain about the health and resilience of the Chinese economy, with visible cracks appearing in the systemically important building and financial sectors.
Australian consumer confidence barely shifted in the past two months: the Melbourne Institute and Westpac Bank Consumer Sentiment Index inched up from 104 in August to 106 in September and down to 105 in October. Retail sales, after contracting for three successive months, rebounded, growing by 1.3% month-on-month. NAB’s index of business confidence surged from -5 in August to +13 in September. The services PMI and manufacturing PMI remained virtually unchanged at 45.6 and 51.2, respectively. Capacity utilisation plunged further, to 78.37% in September, nearly seven percentage points lower than in May. The Westpac-Melbourne Institute Leading Economic Index fell for the fifth successive month but this time only by a miniscule amount, 0.02% month-over-month. Consequently, the six-month annualised growth rate in the Leading Index was revised down from 0.5% in August to -0.5% in September. While these numbers point to a likely contraction in Q3 of this year, they should improve noticeably in the coming months, following the re-opening of the NSW and Victorian economies.
The official cash rate target has been at the historic level of 0.1% for an entire year. For another month, the Shadow Board maintained its unanimous conviction to keep the overnight interest rate at 0.1%: it is has no doubt that the overnight interest rate should remain steady, attaching 0% probability that either an increase is appropriate or a further rate cut to below 0.1%.
The probabilities at longer horizons are as follows: 6 months out, the confidence that the cash rate should remain at 0.1% has strengthened slightly, from 80% in October to 83% in this round; the probability attached to the appropriateness of an interest rate decrease remains exactly 0%, while the probability attached to a required increase correspondingly dropped three percentage points, to 17%. One year out, the Shadow Board members’ confidence that the cash rate should be held steady dropped a mere percentage point, to 61%. The confidence in a required cash rate decrease, to below 0.1%, is 0% (unchanged) and in a required cash rate increase 39% (38% in October). Three years out, the probabilities are unchanged: the Shadow Board attaches a 7% probability that the overnight rate should equal 0.1%, a 0% probability that a rate lower than 0.1% is appropriate, and a 93% probability that a rate higher than 0.1% is optimal. The range of the probability distributions tightened a little over the 6-month horizon, where they extend from 0.1% to 0.5%, and over the 12-month horizon, where they extend from 0.1% to 1.5%. For the 3-year recommendation they remain unchanged, extending from 0.1% to 2.5%.
The September quarter inflation data highlighted both global inflationary pressures (from commodity prices and supply/demand imbalances in goods markets) and the two speed recovery of the domestic economy, with NSW and Victoria lagging behind the rest of the country. With the RBA unable to influence global price moves (and much of these shifts likely to be transitory in inflation terms, as constraints ease and price momentum moderates), the speed of recovery in the largest two states (and further gains elsewhere) will dictate when monetary policy needs to tighten.
The high frequency data suggests that the recovery in the east coast states will be robust, but it is still likely to be mid-2022 before all restrictions (particularly the international border) are fully eased – this will be vital for NSW and Victoria, who are most reliant on services exports. In line with this, moving through H2 2022 and into 2023 the labour market should tighten further, to underpin a pick-up in wages growth, domestic price inflation and ultimately the beginning of a tightening cycle.
The latest year-on-year CPI inflation for Australia is 3.0% and underlying measures are all within the RBA’s 2-3% target range. Combined with a sustained increase in 10-year break-even inflation expectations closer to the target range at around 2%, these inflation developments are welcome news because they mean that real interest rates are lower than they had been earlier in the Covid crisis. Put simply, forward guidance is working and the monetary policy stance is supportive of economic recovery and inflation being in the target range over longer horizons.
However, it is important that the RBA continues its forward guidance and communicates the importance of maintaining the policy rate 0.10% until early/mid 2024 in order to achieve a sustained return of inflation to the target range. Financial markets are likely to continue testing the RBA’s resolve and these tests (in the form of higher medium-term interest rates) will be counterproductive to the RBA achieving its objectives. Questions about the policy can be expected to arise every time other central banks signal or enact policy interest rates. The only way to answer these questions is with clear communication of a strong commitment by the RBA to follow through on its forward guidance.
Any worries about “out-of-control” inflation are misguided and lack perspective. Underlying measures of inflation are back in the target range, but weighted median and trimmed mean inflation are at the low end of the target range, both at 2.1%. Also, there are still base effects from the dip in the CPI with Covid, which are temporarily driving the inflation numbers up. To see this, note that the annualised inflation rate over the two-year period since September 2019 is only 1.8%.
Furthermore, real GDP growth for 2021Q3 is likely to be negative due Covid. While a recovery as a highly-vaccinated Australia opens up is to be expected, it should not be hindered in any way by tighter monetary policy.
Updated: 22 January 2022/Responsible Officer: Crawford Engagement/Page Contact: CAMA admin
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