Cash Rate To Stay at Historic Low A While Longer in Face of Rising Inflation

The annual (headline) inflation rate in Australia rose to 3.5% in the December quarter of 2021, up from 3% in the previous quarter and higher than market estimates. This is well above the RBA’s official target band of 2-3%. However, the RBA’s trimmed mean CPI inflation, an inflation measure which excludes extreme (and typically volatile) values, increased to 2.6%, barely above the target band’s midpoint. The most recent available GDP growth data is the 1.9% contraction measured in Q3 of 2021, when much of the Australian population was in lockdown. GDP growth for Q4 is expected to look much more favourable. The RBA Shadow Board’s verdict is, once again, unchanged from the previous month: it has little doubt (94% confident) that keeping the cash rate at the historically low rate of 0.1% is the appropriate policy for the February round.

The labour market continues to improve; the most recent official ABS unemployment rate fell from 4.6% in November to 4.2% in December. Youth unemployment had also fallen substantially, to 10.9% in November. Total employment grew by nearly 65,000, two thirds of which was full-time. Significantly, the underemployment rate also tumbled for a second consecutive month, to 6.6%, while monthly hours worked increased by approximately 18 million hours, or 1%. Job advertisements surged by nearly 10% in November, and contracted by 5.5% in December. New data on wages growth will not be released until 23 February, but the tighter conditions in the labour market, coupled with an uptick in inflation, suggest we should see an increase in (nominal) wages growth.

The Aussie dollar, after a short rally in December, retreated to where it was two months ago, to around 70 US¢. Yields on Australian 10-year government bonds climbed from a recent low of approx. 1.65% to 1.97%. The yield curves, all of which are showing ‘normal’ convexity, have consequently become a bit steeper. Interest rate spreads have shifted along the maturity profile: for short-term maturities (2-year versus 1-year) the spread is now 32.1 points; in mid-term versus short-term maturities (5-year versus 2-year) the spread is 73 bps and in higher-term maturities (10-year versus 2-year) the spread narrowed to 100 bps. The Australian share market joined other markets worldwide in their recent decline; the S&P/ASX 200 stock index is now trading barely below 7,000, well below the 7,600 high reached in early January.

Risks to the global economy remain considerable, despite many advanced economies rebounding in 2021. On the one hand, Covid-19 poses a continuous challenge. New variants may continue to push back the end of the pandemic and vaccination rates in many developing nations, especially in Africa, are dangerously low to this day. Global supply chains are fractured and are partly contributing to the increase in global inflation. The military and diplomatic stand-off at the Ukrainian border is a real threat to regional peace. This is reflected in high energy prices, which in turn is fuelling headline inflation, and widespread sell-offs in global financial securities. Consensus is now growing that the Federal Reserve in the US will start tightening monetary policy as early as March 2022, adding pressure on other central banks, including the RBA, to follow suit.

Australian consumer confidence softened only slightly, with the Melbourne Institute and Westpac Bank Consumer Sentiment Index falling from 104 to 102 in January. New data on retail sales, which increased by an exceptional 7.3% month-on-month in November, will not be released until next week but are expected to be noticeably weaker. NAB’s index of business confidence plunged in December, from 12, to -12, a direct consequence of the omicron wave. The services PMI and manufacturing PMI are also two months old, so do not offer a reliable reading of the current state of services and manufacturing activity. The rebound in activity, until omicron hit the country, was pronounced – the capacity utilization rate increased more than one-and-a-half percentage points in November, to 83.15, after a jump of more than three percentage points in the previous month. The Westpac-Melbourne Institute Leading Economic Index dropped 0.03% month-on-month in December of last year. The IHS Markit Australia Composite PMI dropped by a full 10 points in January 2022, from 55.1 to 45. All this points to a healthy economic rebound being thwarted by omicron in a short space of time. If predictions that the current Covid-19 wave is about to peak soon prove true, then consumer and business confidence should lift swiftly and put the Australian economy back onto its tracks.

The official cash rate target has been at the historic level of 0.1% for 14 months. While it continues to be very confident that the overnight interest rate should remain steady this round, the Shadow Board’s conviction – in light of recent inflation data – has weakened slightly. It attaches a 94% probability that “no change” is the appropriate policy (down from 100%) and a 6% probability that an increase is appropriate (up from 0%).

The probabilities at longer horizons are as follows: 6 months out, the confidence that the cash rate should remain at 0.1% has softened further, from 75% in December to 59% in the current round; the probability attached to the appropriateness of an interest rate decrease remains unchanged at 0%, while the probability attached to a required increase rose from 25% to 41%. One year out, the Shadow Board members’ confidence that the cash rate should be held steady also fell, from 50% in December to 39% in this round. The confidence in a required cash rate decrease, to below 0.1%, is 0% (unchanged) and in a required cash rate increase 61% (50% in November). Three years out, the probabilities shifted in the same direction: the Shadow Board attaches a 2% probability that the overnight rate should equal 0.1% (down three percentage points), a 0% probability that a rate lower than 0.1% is appropriate, and a 98% probability that a rate higher than 0.1% is optimal (up three percentage points). The range of the probability distribution for the 6-month horizon widened slightly, extending from 0.1% to 0.75%, but remained unchanged for the 12-month horizon, from 0.1% to 2%. For the 3-year recommendation, the distribution again remains unchanged, extending from 0.1% to 2.5%.