Inflation running much higher than central banks expected previously is causing them to rethink the appropriate monetary policy response to tame inflation. Most, including the RBA, are admitting that demand growth is running faster than growth in supply of goods and services and with little chance of materially lifting supply near-term because of continuing supply chain problems made worse by the Ukraine War and China’s Omicron lockdowns, slowing growth in demand towards growth in supply is the only way to cap inflation and bring it back down close to inflation targets. Using blunt-edged monetary policy to batten down demand growth is high risk and could easily go too far. Recession risk is rising.
The central banks’ work slowing demand growth is no easy task. They have come late to the job and with policy settings earlier this year that were set full tilt towards priming demand. Government largesse for households and companies to boot economies out of the pandemic recession boosted growth in demand at a pace unmatched since World War II and have left a legacy of high household savings and strong business and household balance sheets. Labour markets have tightened up considerably with unemployment rates at multi-decade low points either generating inflation supporting wage rises in the case of the US or with wage rises soon to lift to inflation-supporting levels elsewhere.
In order to check what is still strong demand growth momentum central banks have little option but to adopt relatively aggressive monetary policy tightening measures. The US Federal Reserve hiked the Funds rate 75bps at its policy meeting last week to 1.75% and indicated that by this time next year the Funds rate could be close to 4%.
The current and one-year forecast Fed Funds rates look low relative to the most recent annual CPI inflation reading at 8.3%, but that does not mean the interest rates will not place considerable restraint on demand. US businesses and households have borrowed over the past two decades on the basis that borrowing interest rates have been low and falling over time. Even on the occasions when the Fed has lifted interest rates this century it has been in small steps, 25bps at a time. High debt has been amassed on a view that it is and will remain easy to service.
The shock of the Fed hiking 75bps after hiking 50bps at its previous policy meeting and promising more large hikes ahead will have a negative impact on borrowers even though US interest rates at current levels remain negative in real terms. Also, it is likely that negative real interest rates in the US could turn positive over the next year or so as the ‘base effect’ pulls US annual inflation back to 4% or less next year.
Generational change from persistently low borrowing interest rates to higher borrowing interest rates will serve to contain borrowing and demand growth. It will also be a very hard process to dial precisely and there is a high risk that monetary policy induced demand destruction goes too far. The risk of policy error resulting in recession is rising.
Turning to Australia, the RBA has joined the group of central banks recognising that demand growth must be constrained to cap and reduce annual inflation. The RBA admits that it has underestimated the effect of strong demand lifting inflation well above its earlier forecasts through 2021 and early 2022.
RBA Governor Lowe is talking about annual CPI inflation lifting from 5.1% y-o-y in Q1 2022 to 7% by the end of the year (the early May Monetary Policy Statement had the CPI at 5.9% end-year). There are several additions to the already high annual inflation rate approaching including a likely double digit percentage increase in retail gas and electricity prices in Q3, more increases in food, petrol prices and housing rent, and higher mortgage interest rates.
Apart from identifiable price increases approaching, the RBA’s own liaison work with businesses indicates that strong demand is allowing cost increases to pass through to price increases more freely.
Another inflation concern that until recently was less worrying in Australia was wage growth. The Q1 wage price index showing wage growth at 2.4% y-o-y meant little or no wage-push pressure on inflation. That assessment looks set to change. The labour market remains very tight. The May labour force report showed employment up 60,600 in the month, the labour force participation rate at a record high 66.7%, the unemployment rate at 3.9% the lowest since the 1970s and the underemployment rate at a 20-year low. With the labour market drum-tight, the Fair Work Commission decided last week to lift the Minimum Wage by 5.2% and other higher-paying linked awards by 4.6%.
On equity grounds the lower paid needed compensation for the rising cost of living, but the decision comes at a cost in terms of what it will take to return inflation inside the RBA’s 2-3% target range over time. Annual general wage growth will lift from 2.4% y-o-y in Q1 2022 to 4% or more in the first half of 2023. That means that when annual inflation falls back from whatever peak rate it achieves later this year it is hard to see the annual rate falling back inside 2-3% target range in 2023 or 2024. In short, the RBA has more work to do tightening monetary policy in the near-term.
One nasty advantage that the RBA has is that Australian households are likely to be highly sensitive to rising interest rates. Australian household debt relative to income is among the highest in the world. Australian home mortgages are still mostly variable rate and susceptible to increases in the cash rate. Fixed rate mortgages are mostly 2 and 3-year and many are coming up for refinancing over the next 6-12 months. The generational shock moving rapidly from low and falling borrowing interest rates to rising borrowing interest rates is likely to crunch demand, especially the most interest-rate sensitive part, home purchase.
For the time being, the difficulty assessing how high inflation will go and how high it will settle longer term means that the RBA is in the business of battening down demand. That means the 50bps cash rate hike in June may be followed by another 50bps in July to get the cash rate up quickly. How a highly indebted household sector adjusts to higher rates whether slowly reducing borrowing demand or more abruptly will determine whether Australia slides into recession.