In recent weeks we have seen big changes in the market’s assessment of the likely profile for RBA policy over the next few years.
Back in early September the markets expected the cash rate to reach 0.25% by December 2022; 0.65% by December 2023; and 0.95% by December 2024.
That compared with the forecasts Westpac released on June 18 of 0.10% in December 2022 (first hike of 0.15% in the March quarter); 0.75% by December 2023; and 1.25% by December 2024.
So our forecasts, while expecting a somewhat later beginning to the rate hike cycle, anticipated a faster rate of increase in rates over 2023 and 2024 than the market.
Now we see pricing in the market of around 0.60% by end December 2022; 1.35% by December 2023; and 1.65% by December 2024.
Of course, this pricing stands in stark contrast to the RBA’s forecast (not commitment) that it does not expect to increase the cash rate until 2024.
The vast majority of economists are much closer to the RBA’s thinking than the market.
On Wednesday we saw a survey of 24 economists’ forecasts for the timing of the first rate move: 2 were for 2022; 1 (Westpac) for the first quarter of 2023; 5 for the second quarter of 2023; 10 for late 2023; and 6 for 2024.
One very important reason why the RBA is expected to be slow to begin the tightening cycle is the recent change in policy approach.
After having missed the 2.5% target for core inflation (measured by the trimmed mean) since 2014 the previous approach of being pre-emptive has been replaced with the need to ‘play safe’ and actually achieve the target before tightening.
The Governor made that point clear in a speech on September 14, ‘In today’s low inflation world we do not want to run the risk that we increase the cash rate on the basis of a forecast that ultimately does not come to pass, leaving inflation stuck below the target band.’
In the Minutes of the October Board meeting the consistent position was reiterated, ‘It will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range.’
In that September speech he tightened the condition around the inflation rate, ‘It won’t be enough for inflation to just sneak across the 2 per cent line for a quarter or two. We want to see inflation around the middle of the target range and have reasonable confidence that inflation will not fall below the 2–3 per cent band again.’
There is much more ‘flexibility’ on unemployment and wages. The conditions as set out in the Minutes are: ‘achieve a return to full employment’ and ‘generate materially higher wages growth than at the time of the meeting.’
Unlike the specific inflation condition there is no fixed rate set for full employment and while 3% wage inflation has been raised in some speeches a number close to 3% where the trend is clearly for rising wage pressures would most likely be sufficient. We think the RBA sees full employment around 4% but unlike the inflation condition there appears to be flexibility around that target.
The Minutes showed that the Board was, for the first time in a considerable period, prepared to contemplate the prospect of rising inflation – ‘Members noted that while it was possible that underlying inflation pressures in Australia could build more quickly than currently envisaged, the central forecast scenario was still that domestic inflation would pick up only gradually over the medium term.’
That consideration was a step more than the usual one liners featuring ‘ gradual’ or ‘moderate’ with no apparent consideration that inflation might surprise to the upside.
The RBA’s central forecast is for growth in the trimmed mean to hold at 1.75% to December 2021 and remain at that rate in the year to December 2022 and only lifting to 2.25% in the year to December 2023 – still below the 2.5% target.
Those 1.75’s are consistent with quarterly prints of around 0.4%. Of the last 16 prints of the trimmed mean, ten have printed 0.4%; three at 0.5%( including June 2021); and one at 0.3%. The other two (0.0%; and 0.3%) came in the aftermath of the Covid shock in 2020.
So any sign that the trimmed mean was ‘breaking out’ of that ‘0.4%’ straight jacket would be significant
The Importance of the September Inflation Report
The next test will be the September quarter Inflation Report that will print on October 27.
Westpac is forecasting 0.5% for the growth rate of the trimmed mean (TM). That would follow the 0.5% print for the June quarter.
A lift in the six month annualised pace to 2.0% would be significant (but probably not sufficient for an impatient market). The issues which have prompted Westpac to predict that ‘early’ first rate hike could put even more upward pressure on the result.
The dynamic we see for 2022 will be very strong demand ‘colliding’ with disrupted supply to boost inflation pressures. Those supply shocks will be operating in both goods and labour markets.
They will generally boost wage costs as labour markets tighten while supply shocks in goods markets will stem from higher costs of imported durables; rising costs of building materials and potential food cost shocks through shortages from limited supplies of workers.
That dynamic is already operating in a number of sectors – particularly housing (dwelling prices before the application of the HomeBuilder grants were up around 2% per quarter the last two quarters) and motor vehicles (1.8% in the December quarter, 0.7% in the March quarter then 2.2% in the June Quarter).
One of the catalysts for the sharp lift in market yields this week was the surprise jump in the CPI in New Zealand. The CPI was reported to have lifted by 2.2% in the September quarter- the biggest quarterly movement since the December quarter 2010.
The main drivers were housing-related costs such as construction and local authority rates. Prices for construction of new houses were up by 4.5% in the quarter.
This reflects the same pressures we are experiencing in Australia – rising materials costs; increasing labour costs; a booming secondary market allowing developers to widen their margins and booming confidence.
As Justin Smirk discusses in his CPI preview Westpac is forecasting an increase in the price of new construction of 1.8%. In the two previous quarters (March and June) this component has printed –0.1% in each quarter – held down by the Home Building Subsidy that has now ceased, although may still be impacting costs albeit to a much lesser extent. Without the subsidy costs would have lifted by 1.9% in each of the March and June quarters.
At 1.8% dwellings are likely to be ‘trimmed out’ of the trimmed mean. However, as we have seen in earlier periods where a booming secondary market has under pinned construction costs, consistent increases in that component will feed back into underlying inflation in future periods further supporting our expectation that inflation pressures will build through 2022. Given a number of sectors are set to be imputed from the headline CPI in the September quarter, Justin calculates that a ‘shock’ on dwelling prices of around 4% quarter could flow through to the TM boosting it to 0.6% while headline inflation would lift to 1.0% for the quarter.
While our forecast of 0.5% for the TM is sending early signs of the upward drift in the CPI that will allow us to achieve the 2.5% target in the second half of 2022 the markets, with a timing of August/September for the first hike, are going to need more. The markets will require at least 0.6% on the quarterly TM next week.
We have identified the most likely source of such a result but feel that the build up in inflation pressures will be more gradual. The other issue for the markets, which will also be related to the Inflation Report next week, will be whether the RBA responds to market developments and rising global inflationary expectations, and lifts its current cautious inflation forecasts. The November Statement on Monetary Policy will be released on November 5. In that Statement the Bank refreshes its growth and inflation forecasts.
The challenge would be to edge up the inflation outlook without having to abandon the long held guidance that the cash rate will not increase until 2024.
How Should the RBA Deal with Its Yield Curve Control Policy?
To emphasise its commitment to hold rates steady until 2024 the RBA has committed to purchase the government bond that matures in April 2024 at the cash rate of 0.1%.
With the market now expecting a cash rate of around 1.4% by April 2024 this purchase commitment seems to be an anomaly. However, just as the 2.5% inflation target cannot be adjusted (unless as should be the case the RBA and the federal government agreed to lower the target rate to 2%) so the RBA should not walk away from this target.
That can only happen when the Bank actually raises the cash rate. At that point there will be no further responsibility to purchase the bond at 0.1%.
The RBA is known to hold more than 60% of the $32.9 billion on issue of the April 2024 bond leaving only a maximum of around $13 billion outstanding; quite appropriately the RBA is charging very high rates to loan the bonds to the market; and will accept any capital losses on its committed purchases as an acceptable cost of operating an effective and credible monetary policy during extraordinary times.
However it seems unlikely that the RBA will be prepared to make such commitments in the future.
In that regard, consider the average rates on 10 year (1.37%) and 5 year (0.66%) Australian Government Bonds since the RBA began its QE program (which has now reached around $230 billion – including $185 billion AGS) compared to current market rates of 1.82% and 1.10%.
That represents an eye watering mark to market loss but once again collateral damage in the context of the benefits to the economy of an appropriate monetary policy.
In turn , any decision not to hold the bonds to maturity would also be based on monetary policy considerations as to whether, at some point, it was appropriate to reduce the size of the portfolio. If , in the more likely event that it holds the bonds to maturity any ‘loss’ would be purely a reduced income flow.
Conclusion
Only a month ago markets were assessing our forecast profile for the RBA as too aggressive.
That has now changed significantly and we assess that markets have now over shot in terms of the timing and extent of the upcoming tightening cycle.
However, unlike the dominant views of most economists we do accept that conditions will have been reached by end 2022 to justify the first rate hike in the March quarter of 2023.
These conditions are flexible for the unemployment rate and wages growth but quite rigid for inflation.
That inflation objective will be delivered by the collision of strong demand and supply disruptions in both labour and goods markets.
The RBA has adopted a number of unconventional policies in this cycle to address the challenges of the COVID Crisis – on a mark to market basis these policies appear to be expensive but in the scheme of ensuring a responsive policy approach in extraordinary times have been a small price to pay
