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Despite weak wages growth, the labour market remains buoyant and inflation, at 6.1% (Q2 of 2022 for headline CPI and 4.9% for core inflation), well above the RBA’s target band of 2-3%. Other indicators also suggest that inflation will remain elevated for a while: a historically high capacity utilisation rate, global supply chain constraints, and high energy and food prices. Consequently, the RBA Shadow Board strongly advocates in favour of further interest rate increases. It is 89% confident that the overnight rate should be raised to above the current setting of 1.85%, with a mode recommendation of a 50 bps increase, whilst only attaching an 11% probability that keeping the overnight rate on hold this round is the appropriate policy.
Australia’s seasonally adjusted unemployment rate dropped further, to a new record low of 3.4% in July 2022. Youth unemployment, too, dropped, from 7.9% to 7.0%. Total employment fell by 40,900; however, the labour participation rate, after reaching a historic high of 66.8% in June, fell to 66.4%, explaining why this drop did not raise the unemployment statistic. Unsurprisingly, total monthly hours worked in all jobs also fell, by 16 million, or 0.8%. Other labour market indicators such as underemployment, job vacancies and job advertisements remain strong, painting a favourable picture overall of the Australian labour market. The seasonally adjusted wage price index grew by 2.6% year-on-year in Q2, up from 2.4% in the previous quarter, but slightly below market forecasts. This number implies a further erosion of real wages and raises the puzzling question why nominal wages are not able to keep pace with inflation. There is growing concern among workers, unions, policy makers and even some businesses that real wages need to rise, along with productivity.
After a small rally early in the month, the Aussie dollar retreated, finishing the month of August a little above 68 US¢. Should the Federal Reserve in the U.S. continue to tighten monetary policy aggressively and the RBA does not follow the U.S. lead, the widening interest rate gap will put downward pressure on the Aussie dollar and make imports more expensive. Yields on Australian 10-year government bonds have resumed their climb, to around 3.7% at the end of August. Interest rate spreads increased slightly and yield curves retain their normal convexity. The spread between 10-year versus 2-year bonds now equals 49 bps. Australian stock prices again emulated the behaviour of the Aussie dollar – after a temporary high in the middle of August, stock prices dropped: the S&P/ASX 200 stock index finished the month just above 6,850, a 300 point decline in the space of two weeks.
Consumer confidence continued its decline: the Melbourne Institute and Westpac Bank Consumer Sentiment Index dropped for the ninth month in a row, from 83.8 to 81.2. July retail sales, on the other hand, were healthy. Business confidence is mixed; NAB’s index of business confidence jumped from 1 in June to 7 in July, as did the services PMI (from 48.8 to 51.7, July), while the manufacturing PMI and the S&P Global Australia Composite PMI dropped again (from 52.5 to 49.3 and from 51.1 to 49.8, in August, respectively). Remarkably, the capacity utilisation rate increased by nearly two percentage points, to a new historic all-time high of 86.68%. In the same month, the Westpac-Melbourne Institute Leading Economic Index declined by 0.2% year-on-year, for the second month in a row.
Australian house prices recently experienced their biggest monthly decline in several decades, according to CoreLogic, as higher interest rates, and the prospect of further increases, are weighing on demand, particularly for first home buyers. A further decline in dwelling values is widely expected, well into 2023, before the market is likely to stabilise. Lower house prices, coupled with higher interest costs, should put the brakes on aggregate demand, thus easing inflationary pressures, but it may yet be months before this wealth effect works its way through the economy.
The impact of fiscal policy will become much clearer in a couple of months, after the Government announces its first budget. Some significant structural policies may also come out of the recent Jobs and Skills summit.
Uncertainty around the global economic outlook remains high. Strong U.S. consumption, fuelled by government stimulus funds and $2.5 trillion of excess household savings, according to the Brookings Institution, was matched by a healthy expansion in U.S. manufacturing. However, factory activity in other parts of the world, particularly in China and Europe, fell. There are growing signs that several Eurozone countries risk sliding into recession, with the possibility of severe disruptions on the back of gas shortages and high energy prices. Global supply chains continue to be obstructed owing to China’s Covid-19 response and geopolitical tensions. These are unlikely to ease any time soon.
Four months ago, the Reserve Bank of Australia embarked on a tightening cycle after the official cash rate target stood at the historically low level of 0.1% for one-and-a-half years. For the current (September) round, the Shadow Board is advocating that the overnight interest rate be raised further, above the current level of 1.85%, attaching an 89% probability that this is the appropriate policy stance. It attaches an 11% probability that keeping the overnight rate on hold is the appropriate policy and a 0% probability that a decrease is appropriate.
The probabilities at longer horizons are as follows: 6 months out, the confidence that the cash rate should remain at the current setting of 1.85% equals 1%; the probability attached to the appropriateness of an interest rate decrease equals 5%, while the probability attached to a required increase equals 94%. One year out, the recommendations are similar. The Shadow Board members’ confidence that the appropriate cash rate is 1.85% equals 0%. The confidence in a required cash rate decrease, to below 1.85%, is 3% and in a required cash rate increase, to above 1.85%, equals 98%. Three years out, the Shadow Board attaches a 0% probability that the overnight rate should equal 1.85%, a 7% probability that a lower overnight rate is optimal and a 93% probability that a rate higher than 1.85% is optimal.
The range of the probability distributions for the current and 6-month recommendations shifted up, along with the 50 bps increase of the overnight rate: for the current setting, it extends from 1.85% to 3%, and for the 6-month horizon it extends from 1.5% to 4.25% (compared to a range of 1.0% to 3.75% in the previous round). The range for the 12-month horizon widened substantially in both directions of the distribution, reflecting heightened uncertainty about future upside and downside risks. The range extends from 0.5% to 5.0% (compared to a range of 1.0% to 4.75% in the previous round). For the 3-year horizon the range widened by 50 bps to the downside, extending from 0.5% to 6.0%
The Australian economy remains strong. In the last few days, A.B.S. reported a 7% increase in the number of businesses (although 84 % of them are non-employing businesses) and a 1.3 % increase in retail turnover. Furthermore, supply chains are starting to normalise (e.g. container freight rates are declining as are covid related restrictions) and global inflation rates seem to also go down. While these are all certainly good news, it is too early to declare victory and too early to stop the monetary policy tightening. In my view, the policy cash rate still needs to increase further to anchor expectations and deliver inflation rates within targets.
The latest data has generally surprised on the upside, with businesses still reporting buoyant trading conditions and ongoing constraints with worker shortages (a sign that demand is still outstripping supply) and consumers maintaining a brisk pace of spending despite mounting headwinds from cost of living pressures and rising interest rates. This suggests that the positive supports of an elevated savings rate, excess savings and increases in employment have so far more than offset the drags from inflation and monetary tightening.
Growth momentum will inevitably slow, and there are now some signs of this in the labour market data (where growth in employment has moderated) and in the construction sector and property market. But the ongoing strength in demand means it continues to outstrip the economy’s supply side capacity. This is feeding local inflationary pressures, and there is a need for further increases in the cash rate to counteract this trend; monetary tightening will ultimately dampen the pace of demand growth, to realign aggregate demand with supply and cool inflation.
The resilience of the economy has prompted a rapid pace of rate rises from the RBA Board to date, a slowdown in the pace of rate rises is now appropriate, to give the Board time to assess the impact of the tightening to date and decide on future increases. Over the next six months it will likely be appropriate for the cash rate to move beyond its neutral level, to decisively dampen demand and ensure that inflation expectations remain well-anchored.
The Reserve Bank of Australia should continue to increase the cash rate and do so until inflation moderates. Underlying measures of inflation are currently running close to 5 per cent in year-ended terms. The Federal Reserve in the United States has increased its policy rate at a faster pace than the RBA which has contributed to a weaker Australian dollar. The depreciation of the exchange rate will add to inflationary pressures at home through further increases in tradable goods prices. Although inflation has been surprisingly (and persistently) high, inflation is likely to moderate over the medium term (1 to 2 years), as suggested by the yield curve. But this expectation is predicated on monetary policy responding to the increase in inflation. Because the real rate of interest at the short-end of the yield curve remains quite negative, the stance of monetary policy continues to be expansionary. And considering that the rate of unemployment is at a historically low level, the cash rate has to increase.
The August SMP projected the cash rate to rise to 3% by end-2022, then decline by end-2024. This path is too low. The RBA expects it will deliver underlying inflation above the target range and unemployment below the NAIRU throughout the forecast horizon. A higher path of interest rates would move both these variables closer to their targets, so is unambiguously preferable. Moreover, I am sceptical of forecasts that inflation will quickly return to target while U<NAIRU.
Updated: 27 September 2022/Responsible Officer: Crawford Engagement/Page Contact: CAMA admin
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