The November SOMP provides some more detailed arguments behind the key forecasts which make the case for a delayed beginning to the rate hike cycle. Much of the detail in these cases should be interpreted that the risks are firmly pitched towards Westpac’s timing that the conditions will be appropriate for a first rate increase in February 2023.
The Reserve Bank’s Statement on Monetary Policy (SOMP) for November is less intriguing than usual because the key forecast changes were set out in the Governor’s Statement following the Board meeting earlier in the week.
The Board’s key themes were further explained by the Governor in a separate speech and Q and A session later in the afternoon following the Board meeting.
The key to the policy debate is the timing of when the Bank achieves its objectives of underlying inflation sustainably at 2.5%; full employment; and wages growth “materially higher than it is currently.”
Westpac expects those conditions will be met in time for a February 2023 beginning to the tightening cycle. The Bank’s forecasts indicate a much more delayed timetable.
Our analysis of the SOMP focuses on the Bank’s evidence to support its forecasts and associated timing of the policy change.
To recap the key forecast changes from the August SOMP.
Note that the forecasts use market pricing for the interest rate outlook which imply the first cash rate increase will be mid 2022 with the cash rate to increase to 1.5% by end 2023.
Inflation (Westpac forecast 2.8% in 2022)
Forecast growth in the Trimmed Mean (measure of underlying inflation) has been lifted from the 1.75% in the August SOMP to 2.25% in 2022 and 2.25% to 2.5% in 2023.
The SOMP does provide some useful insight into this change by noting that the 2.5% growth in the Trimmed Mean is not expected to be reached until December with the June forecast holding at 2.25% – that provides empirical support to the theme that if the Bank is prepared to anticipate a rate hike earlier than 2024 then it would be in the second half of 2023 at the earliest.
Wages (Westpac forecast 2.75% in 2022)
Forecast growth in the Wage Price Index is unchanged at 2.5% in 2022 but has been lifted from 2.75% to 3.0% in 2023, although the June 2023 forecast is for 2.75% rather than 3%.
Unemployment Rate (Westpac forecast 3.8% in 2022)
The unemployment rate forecasts are unchanged at 4.25% for December 2022 and 4% for December 2023.
Economic Activity (Westpac forecast 7.4% in 2022)
The forecast contraction in GDP in the September quarter has been revised from “more than 1%” to “around 2.5%”.
Forecast growth in 2022 has been lifted from 4.25% to 5.5%, largely reflecting the additional catch up required from the deeper than expected contraction in the September quarter. Forecast consumption growth in 2022 has been lifted from 6% to 7%; dwelling investment from –0.5% to 6.5%; and business investment from 9% to 10.75%.
The Policy Outlook
Even though the Governor’s Statement deleted reference to 2024 and the central scenario for policy lift off the SOMP clearly expresses the Board’s ongoing preference for 2024 albeit with some caveats.
This policy outlook is enunciated in the SOMP’s Overview with “Depending on the trajectory of the economy at that time, the Board judges that this outcome (central scenario) could be consistent with the first increase in the cash rate being in 2024”.
However, it is noted that some other plausible scenarios could warrant an increase in the cash rate in 2023.; but the latest data and the forecasts do not warrant an increase in the cash rate in 2022.
The most interesting aspects of the discussion on the economy were around wages; inflation and unemployment.
The commentary on the September quarter Inflation Report noted that around two thirds of the quarterly increase in the CPI were accounted for by fuel prices and home building costs- “although prices of some consumer durable goods picked up as import price pressures persisted and demand remained strong, inflation was fairly subdued in other expenditure components.”
A key driver of the pick-up in new dwelling inflation was the strong rise in raw materials costs which increased by 4% in the quarter and 8% over the year- the fastest pace since the 1980’s while the strong demand induced by subsidies also boosted prices.
The best “clue” to the Bank’s forecast for such a modest lift in inflation in 2022 (only 2.25% for the Trimmed Mean) is liaison information suggesting that firms absorbed upstream cost pressures, although it does note that household appliances and furnishings retailers have started passing higher upstream costs to consumers.
The Bank does note that “supply chain related cost pressures and the extent of pass through to consumers remain an upside risk to tradeable goods nflation in the year ahead.”
On the other hand, it is noted that since many “dining vouchers” could not be used in the September quarter they will weigh on measured market services prices in future quarters.
Rents were soft in the September quarter, although advertised rents suggest increases in the year ahead.
Inflation expectations have increased as well, in particular unions in the short term (up to 3%) and long-term expectations have increased to 2.5%.
There are a number of factors the Bank notes to justify only gradual increases in wages growth. Spare capacity remains in the labour market while it points out the inertia in the wage setting process.
On wages, the weak 0.4% print for the June quarter WPI showed soft growth across most industries. The share of jobs subject to wage freezes remained elevated particularly for individual agreements.
Information from the Bank’s liaison program suggests that rather than raise base wages many firms experiencing difficulties finding labour have been using other strategies to retain and attract employees., including sign on and retention bonuses; workplace flexibility, internal training and relying on less experienced staff. However, where shortages were acute wages growth had been strong.
Looking forward, the liaison work reports that firms are generally reporting an expected return to annual wage rises of 2-2.5% over the next year. The distribution of wage rises is generally consistent with the pre pandemic pattern with only a quarter of firms expecting wages growth to be more than 3%.
The Bank seems to be basing its forecasts on current conditions. But the risks to this gradual, almost gentle, lift in wages and inflation, seem to be to the upside particularly when even on the Bank’s more cautious forecasts the unemployment rate is set to fall to 4.25% by end 2022 – near the lows we have not seen since 2007.
Expect strong demand (over 7% growth) in 2022. There is a clear likelihood that supply restrictions including in labour markets (relief from shortages from borders reopening will be gradual; some restrictions from unvaccinated workers) will persist for longer than expected
The elimination of the subsidy for new building will boost measured prices of housing construction; price expectations are rising; some retailers are passing on costs and some employers are already having to respond to shortages.
Conclusion
The SOMP maintains a clear case for the conditions required to justify the beginning of the rate hike cycle to be 2024, with a possibility of late 2023.
The case relies on very gradual response in inflation and wages to the current developments despite a strong recovery in the economy; supply constraints in goods and labour markets; rising inflationary expectations; some evidence of firms’ asserting pricing power; and firms having to resort to various tactics to hold down wage increases.
The risks to these scenarios look to be pitched to the upside and Westpac continues to anticipate that the necessary conditions for the first-rate increase will come much sooner than envisaged in the SOMP’s forecasts.
