Australia on Path to Recovery But Cash Rate Must Stay On Hold for Now

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%.