The latest set of economic forecasts released by the RBA in the November Monetary Policy Statement again show upward revisions to annual change in wages and inflation expected in 2022 and 2023. Indeed, the revisions are the biggest so far in a series of upward revisions each quarter over the past year. The RBA’s latest “Central Scenario” forecasts now have annual growth in the wage price index ranging 2.25% to 3.0% between Q4 2021 and Q4 2023; trimmed mean inflation ranging 2.25% to 2.5% over the same period; and the CPI 3.25% in Q4 2021, retreating to 2.25% late 2022/early 2023 before reaccelerating to 2.5% in Q4 2023.
Just three months ago the same set of forecasts for the same period was wage price index 2.25% to 2.75%; trimmed mean inflation 1.75% to 2.25%; and CPI 2.5% in Q4 2021, down to 1.5% mid-2022 before reaccelerating to 2.25% in Q4 2023. Over only three months between August and November these forecast changes are remarkable, especially the increases to the nearest period inflation forecasts, Q4 2021, with trimmed mean and CPI inflation forecasts up respectively 0.5 and 0.75 percentage points.
A year ago, in the November 2020 Monetary Policy Statement, the RBA forecast Q4 2021 wage price index at 1.25% and trimmed mean and CPI inflation both at 1.0%. Over the past year, Q4 2021 RBA forecasts for annual wages growth have increased one percentage point; trimmed mean inflation 1.25 percentage points and CPI 2.25 percentage points. The RBA has form for under-forecasting wage growth and inflation and that implies its latest “Central Scenario” forecasts that have wage growth and inflation on the boundary to justify a cash rate hike in the second half of 2023 may on revision in February and May 2022 come forward to the second half of 2022.
We also have to recognise that changing RBA wage and inflation forecasts that in the past would have driven the RBA to hike rates do not drive policy changes these days. The RBA like many of its central bank peers internationally has changed its inflation-fighting spots over recent years. In the past, the RBA would look ahead using its forecasts to judge when inflation might run up through its 2-3% target band and would hike ahead of a forecast unacceptable lift in inflation. The idea was that pre-emptive policy action would be a “stitch in time” heading off inflation before it could become entrenched requiring more substantial policy action. Pre-emptive monetary policy meant that policy changes could be smaller and still be effective.
Another reason why pre-emptive policy action made sense was the lags gathering information about inflation and when an interest rate change takes effect. The CPI is released nearly a month after the quarter to which it relates. We do not see upward pressure on inflation in the statistics until several weeks after it has occurred. An official interest rate change doesn’t start to affect economic decisions for at least three months.
Over recent years pre-emptive monetary policy has been abandoned in favour of reactive monetary policy or hiking interest rates only on firm proof that inflation has persistently moved above target. The RBA, once a champion of pre-emptive monetary policy setting has become an equally fervent champion of reactive monetary policy over recent years. At the heart of reactive monetary policy is a view that in a world where long-term disinflationary forces are still in play – downward price pressures from rapid technological change, competition through globalisation and demograhic change – upward pressure on inflation is cyclical and temporary unless the economy is operating at full-employment driving up wages to sustain further inflation increases.
The old virtues of pre-emptive monetary policy setting are more than countered by the risk that hiking rates early may quell temporary inflation that would have settled back of its own accord. The higher official interest rates would reduce economic growth and employment growth unnecessarily.
Even the firmly reactive RBA, however, seems to have been shaken by higher than forecast Q3 2021 annual underlying annual inflation at 2.1% y-o-y on a 0.7% q-o-q increase. It has had to increase its near-term inflation forecasts, abandon its 3-year bond yield target and drop its interest rate guidance that the official cash rate at 0.10% would not rise before 2024 at earliest. There is now concession that the cash rate could rise in 2023 although it is still unlikely to rise in 2022.
The RBA still stresses that its Board will be “patient” monitoring wage and inflation developments, a sign that even if it has to lift its wage and inflation forecasts again in February 2022 (almost inevitable in our view) that may still not be enough to promote a rate hike.
If the RBA remains committed to reactive monetary policy setting it will wait for measured annual wages growth to lift above 3% y-o-y. The latest Q2 wage price index showed 1.7% y-o-y on a 0.4% q-o-q increase. The Q3 wage price index (covering the period of Melbourne and Sydney lockdowns) due out next week may still be subdued around 0.5% q-o-q, but taking annual wages growth above 2% y-o-y.
The wage price index readings in Q4 2021 (due February 2022) and Q1 2022 (due May 2022) will almost certainly be materially higher on quarter-on-quarter basis, reflecting much higher wages starting to be paid in several sectors of the post-lockdown, sharply recovering Australian economy. The quarterly wage price index changes are likely to jump to 0.8% or higher in Q4 2021 and Q1 2022 driving up measured annual wages growth to 3%+ y-o-y in mid-2022.
Even the reactive RBA will have cause from the wage data to hike the cash rate in the second half of 2022. By then, inflation will probably be well entrenched around 3% y-o-y and rising. That implies the need for more rather than fewer rate hikes to contain inflation. The RBA is saying that even when it does start to hike the moves will be small and slow. It will start tightening reactively and stay reactive through the tightening cycle.The risk is that inflation takes much longer to contain and the rate hiking cycle becomes unusually protracted. Reactive monetary policy setting comes with the benefit of an extended economic recovery but it also comes with the longer-term cost of higher inflation and an extended, multi-year slow rise in borrowing interest rates.