Last week we looked at the approaching run of Q2 GDP reports for major economies starting later today with China. Our conclusion was that the pace of global economic stepped up in Q2, extending to better growth in Australia too. We indicated that better growth would be one factor extending an upward correction in global bond yields. This week we look at inflation, another factor likely to push up bond yields, but most likely later in the year. Unlike GDP growth, inflation looks contained in Q2, but is starting to lift in Q3 and beyond, including in Australia. The combination of firming economic growth and the beginnings of a turn up in inflation make it highly likely in our view that the RBA will start hiking the cash rate in 2018.
Almost certainly, the low point for Australian annual CPI inflation in the current cycle was in Q2 2016 when it registered 1.0% y-o-y. Since that time annual inflation has been on a modest climb to 1.3% in Q3 2016, 1.5% in Q4 and 2.1% in Q1 2017. The Q2 2017 CPI will be released later this month (26th July) and on our forecast, should show a rise of around 0.4% q-o-q which would hold the annual inflation rate at 2.1%. Taken at face value, that would seem to show that annual inflation is higher than it was last year, but is stabilising and at an annual rate still at the lower end of the RBA’s inflation target range of 2% to 3%. There is not yet an inflation target-based argument for the RBA to think about lifting the cash rate, although the lift in annual inflation over the past year means that the 1.50% official cash rate has moved in real terms from +0.50% in Q2 2016 to -0.60% in Q2 2017, one marker that the cash rate is now too low.
The issue for the RBA is whether annual inflation after probably pausing in Q2 2017 around 2.1% y-o-y is set to start climbing again and threaten to rise to the top of the 2-3% target band over the next year or so. Importantly, we do not see it as a requirement for inflation to push above the 3% upper limit of the inflation target band for the RBA to start hiking the cash rate. If, for example, inflation pushed up to say 2.7% and stay there for a few quarters, that would imply that the current 1.50% cash rate – extending down to -1.20% in real terms – is far too stimulatory.
In the last full set of economic forecasts produced by the RBA in its May Monetary Policy Statement, the RBA forecast annual inflation at 2.0% y-o-y in Q2 2017 but beyond Q2 in a 1.50% to 2.50% range through to end-2018 before lifting to 2% to 3% range in June 2019. These inflation forecasts imply the RBA probably starting to hike the cash rate late in 2018. One problem, is that when the RBA produces its next set of forecasts in early August and has available the latest Q2 CPI plus other information gathered over the last few months it is likely to be hard to pitch credibly the low end of its inflation forecasts from end-2017 through end-2018 at 1.5%. If the RBA lifts the low- end forecast to 1.75% that implies new inflation range forecasts of 1.75% to 2.75% from late 2017 through late 2018 and brings the likely timing of the start of hiking the cash rate forward to early 2018, possibly even late 2017.
Perhaps the key factor holding down the RBA’s inflation forecasts has been persistently very low wages growth. Since May there have been signs that the period of extremely low wages growth is close to ending. Employment growth has picked up sharply in March, April and May. Job vacancies have lifted strongly. The unemployment rate has fallen to a 4-year low 5.5%. All these signs point to a tighter labour market and the possibility of higher wages growth. Also, the recent national Minimum Wage Case granted a bigger-than-expected wage rise close to 3% y-o-y. It is unlikely that wages growth will stay as low as it has been or as low as assumed in the RBA’s May inflation forecasts.
There are also pockets of higher inflation developing in the housing component of the CPI. The most significant is higher energy prices from July 1st. They will feed directly in to the Q3 CPI (due in late October) through the housing component and indirectly will feed higher producer prices adding to various components of the CPI beyond Q3. Higher council land rates, higher house prices and higher house rents are also likely to feature in Q3. It is possible that annual inflation could blip upwards towards 2.5% y-o-y in Q3 and although it may settle a touch lower beyond briefly it now looks likely that each of the four quarterly CPI readings in 2018 will show annual inflation above 2%.
The combination of somewhat better growth (our article published last week) and rather higher inflation implies that Australian government bond yields will be upwards of 50bps higher by this time next year. It also implies that the RBA will hike the cash rate 25bps to 1.75% either late this year or early in 2018 and may have hiked a second time to 2.00% by this time next year.