The RBA has revised higher its near-term outlook for Australian economic growth and has revised downwards its unemployment rate forecasts. It has also tweaked higher forecast inflation and now sees headline and underlying annual inflation pushing above 2.0% in 2019. In the latest quarterly Monetary Policy Statement released last Friday the RBA is now forecasting above trend GDP growth over the next two years stretching capacity to the point of raising annual wages growth and inflation. Although the RBA expects that the growth-accommodating 1.50% cash rate will need to be increased it does not expect that it will be increased in the near-term.
While the RBA is forecasting that already strong Australian economic growth will get even stronger in the next six-to-twelve months it is still worried by potential downside risks to its forecasts, especially how household spending will perform as house prices continue to slide. While the RBA’s concern about potential weakness in household spending is understandable it is worth noting that the weakness in house prices has been running for a year and there is no evidence that it is denting household spending growth. Indeed, household spending growth has accelerated mildly over the past year.
It is not just lower house prices that might dent household spending growth, soft wages growth is an issue too from the RBA’s point of view. The RBA expects that annual wages growth will gather pace, but the acceleration will remain gradual. At the same time the RBA acknowledges that more pockets of skill shortages and higher wage pressure are starting to show. If the unemployment rate continues to fall in line with the RBA’s latest forecasts, down to 4.75% by mid-2019 inevitably upward pressure on wages will grow. In our view, there is a growing risk that annual wages will cease being gradual in 2019 and will start to lift more sharply.
The latest labour force and wage reports are due this week and may provide indications of more strength in employment and the beginnings of a more pronounced lift in annual wages growth. If this is the case, the RBA may already face the need for further upward revisions when it revisits its economic forecasts again formally in February 2019.
In one sense this phase of needing to upgrade economic forecasts on a three -monthly basis is a consequence of the RBA leaving its cash rate too low. As the RBA admits, the 1.50% cash rate is supporting stronger economic growth and at a time when the economy has been growing above trend and is expected to grow above trend for the next year or two.
The low cash rate is also a force keeping the Australian dollar lower countering other forces such as rising Australian export prices and terms of trade that would tend to place upward pressure on the currency. The highly competitive Australian exchange rate is reinforcing Australia’s burgeoning international trade surplus and is helping fast reviving investment interest in Australian export capacity.
A record low cash rate and a very competitive Australian dollar at a time when much of the Australian economy – other than housing activity – is growing strongly will drive even stronger general economic growth. In our view the upward pressure on wages and inflation will become much more pronounced in 2019.
We expect mostly strong Australian economic data readings over the next three months to drive a further set of upgrades to the RBA’s GDP growth and inflation forecasts in February. The unemployment rate forecast may need to be revised lower as well. If these adjustments to the RBA’s forecasts prove to be necessary, the RBA will probably hike its cash rate 25bps to 1.75% at its February policy meeting just ahead of the February Monetary Policy Statement.
Providing inflation does not lift too quickly in 2019, the RBA may be in position to move the cash rate up relatively slowly with a second 25bps cash rate hike to 2.00% later in the year.
There is a risk, however, that inflation internationally and in Australia picks up more sharply than is widely expected. Some markers of higher inflation pressure ahead are evident in final stage producer prices which on the most recent readings are up 2.9% y-o-y in the US, 3.3% y-o-y in China and 4.5% y-o-y in China. Producer prices have also been lifting sharply in Australia as well, up to 2.1% y-o-y in Q3 from 1.5% y-o-y in Q2. Wages growth has also started to rise more sharply in the US, Germany and Japan up around 3% y-o-y signaling that the long phase of low wages growth is perhaps ending.
If higher-than-expected inflation does start to show through in 2019, the RBA would need to restore the cash rate relatively quickly to 3.00% (a neutral setting), or higher. At this stage, we do not expect inflation to lift too quickly, but the longer the RBA persists with a very low cash rate the greater the risk that too strong economic growth will prompt a burst of too-high inflation.
It has often been remarked in the past that monetary policy setting is often about the line of least regret. We believe the line of least regret for the RBA is starting to shift away from risk of too weak household spending and towards increasing risk of higher inflation. The long phase of a record low cash rate is coming to a close and we believe more quickly than is widely recognised.