The May employment report is a major ‘game changer’ for policy. It underscores the strength of momentum in the economy and endorses the range of other measures pointing to a very strong labour market.
The recovery is now clearly into a self-sustaining upswing and the need for emergency stimulus policies has eased significantly.
Taken with yesterday’s clear signal from the Federal Reserve that wider economic risks from the health emergency have eased and policy normalisation can be brought forward the challenges facing the RBA are changing.
The stunning fall in the unemployment rate from 5.5% to 5.1% in May, which aligns with other supportive data on the labour market, has substantially lowered our forecast profile of the unemployment rate.
Our growth forecasts (incorporating risks around local lockdowns and the timing of the reopening of the foreign border) are consistent with a fall in the unemployment rate of around 1 ppt between June 2021 and June 2022.
Our analysis of the May employment report points to a convincing, sustainable improvement in the labour market. We do not assess this report as a “one off”.
We have adjusted our unemployment forecasts to take this into account.
With the starting point for the unemployment rate now at 5.1% rather than the 5.5% we had previously expected for May 2021 we now forecast that the unemployment rate will reach 4.0% by June 2022 and will drift down through the second half of 2022 to reach 3.8% by year’s end.
We assess 4.0% as full employment and we expect the RBA has a similar view.
Reaching full employment much earlier than previously expected points to upward pressure on both inflation and wages growth.
We now expect underlying inflation to reach 2.25% and wages growth to reach 2.75% by December 2022.
These parameters are broadly in line with the RBA’s own ‘upside scenario’ in their May Statement on Monetary Policy where the unemployment rate reaches 4% in December 2022 before falling to 3.75% by June 2023.
Over that six- month period underlying inflation lifts to 2.25% while wages growth reaches around 2.75%.
In effect our forecasts, incorporating the strong employment report for May, are running six months ahead of the RBA’s ‘upside scenario’.
IMPLICATIONS FOR MONETARY POLICY
We now expect that the RBA will assess that it has achieved the conditions necessary for the first interest rate hike by the first quarter of 2023.
We expect an increase of 15 basis points in Q1; to be followed by 25 basis points in Q2; and 25 basis points in Q4.
That would restore the cash rate to 75 basis points by end 2023, in effect reversing the ’emergency’ rate cuts in 2020 when the RBA responded to the COVID crisis.
Recall that the RBA will have ceased QE in mid- 2022 but will still hold around 18% of GDP in bonds – providing ongoing stimulus to the economy.
Note that we do not believe that wages growth will have to exceed 3% as a condition for the initial rate increase.
To that point it is interesting that the Governor’s latest speech defined the conditions for a rate hike around wages growth as “wage increases will need to be materially higher than they have been recently”.
That equates with the wages growth “condition” which has been consistently used in Board minutes and the Governor’s statements following Board meetings.
The “sustainably above 3%” condition has been used as a guideline in some of the Governor’s speeches.
The key conditions for raising rates are “actual inflation is sustainably within the 2-3% target range” and “return to full employment” both of which we expect to be met by end 2022.
We think there may be some flexibility around the 3% wages growth condition.
THE JULY BOARD MEETING
We maintain our view that the Board will decide not to switch its Yield Curve Targeting policy from the April 2024 bond to the November 2024 bond.
We interpreted that a decision to extend the target to November 2024 would only have been likely if the Board gave a reasonable probability to the first interest rate increase being in 2025.
While the Board may still be of that view , for now, and 2024 is more likely than our forecast of 2023 it seems highly unlikely that it would give a significant probability to 2025.
Westpac was the first in the market to forecast that the Bank would adopt a flexible approach to its bond purchase program.
With prospects for an earlier than expected rate increase the Bank will be even more comfortable with the flexibility afforded by a weekly target.
We expect that it will adopt a $5 billion weekly target with a review likely by the December Board meeting.
That will accumulate around a further $65 billion in bond purchases, with the pace of future purchases being cut- back, in the new year.
We still expect purchases, at a slower pace, to continue through to the middle of 2022.
Westpac’s fair value model for the AUD is currently around USD0.90.
Without doubt, the QE policy which the RBA has adopted has been a key factor behind the AUD, holding well below its fair value.
The RBA will assess that result as emphasising the success of the policy.
The one really significant other change that is likely in the Governor’s Statement is the sentence “this is unlikely to be until 2024 at the earliest”. While the Governor will not adjust the wording to “2023 at the earliest” he may change the sentence to something like “this is unlikely to be for some time.”
THE FEDERAL RESERVE
The RBA is always mindful of the policy outlook for the Federal Reserve.
Following the announcement from the Fed yesterday and the Chairman’s press conference we have brought forward our forecasts for the first tightening by the Fed to December 2022.
We expect two further hikes in 2023 in March and June.
We also expect that the Chairman will announce in September that the Fed expects to begin its tapering of bond purchases by January 2022 with an objective of completing the program by June 2022.
While the RBA will be slower to announce its tapering plans we expect it will be targeting a similar staged tapering to the Fed with respect to its QE program.
THE AUSTRALIAN DOLLAR
Prospects for higher interest rates will provide support for the AUD.
Recent weakness in the AUD against the USD is likely to reflect the market’s assessment of a much earlier tightening cycle in the US than in Australia.
Our view is that the tightening cycles will now be closely aligned. As discussed, our fair value model for AUD is now around USD0.90.
We continue to expect that the wide gap between AUD and fair value will narrow over the course of 2021 although we have shaved our end 2021 target to USD0.80 from USD0.82 and end 2022 target from USD0.85 to USD0.84.
THE RISKS
Westpac is concerned about the risks to the outlook posed by the health threats from the interaction between Australia’s low vaccination rate; unstable hotel quarantine system; and commitment by state governments to zero transmissions.
On the other hand there are upside risks linked to the ample scope for draw down in savings by households; the wealth effect of the current housing boom and the associated spin off activity; strong recoveries offshore; a smooth reopening of the borders; and another expansionary Federal Budget as the next election looms.
Readers will not be surprised that we do assess the current range of uncertainties in both directions as larger than normal.
Note that our forecasts are for 4.8% growth in 2021 followed by 3.2% in 2022 with a further slowing in 2023 to around trend.
These forecasts are well below the RBA’s upside scenario forecasts of 6% in 2021 and 4.5% in 2022 although we have comparable labour market; wages and inflation forecasts.
This may indicate the RBA’s caution around the links between the labour market and real spending compounded by a very conservative view on the interaction between the real and nominal economies.
Without doubt there have been significant structural changes since GFC although perhaps years of overstating inflation and wages growth are now scarring their confidence in these transmission mechanisms.
As we move forward into 2022 we expect the RBA will adopt a less cautious approach to these relationships.
BOND AND SWAP RATES
We have lifted our three-year swap forecasts by around 20 basis points to reflect the earlier rate hikes but held our long-term bond forecasts steady.
Readers will be aware that we have had a bearish approach to ten-year bond yields reaching 2.5% by the end 2022 and 2.9% by end 2023.
Our key dynamic has been the expectation of a gradual normalising of policy, including tapering of QE, that will hold current inflation break even components steady but lift real yields into positive territory as markets react to policy normalisation.
Today’s forecast changes have brought forward these policy adjustments but not substantially changed the underlying dynamics.
