Senior RBA officials remain adamant that official interest rates will not need to rise until 2024, at the earliest. The message will be reinforced again when RBA Governor Philip Lowe speaks this week and despite repeated admissions that the economy is recovering more strongly than expected. The key themes in RBA commentaries remain that while economic growth is surprising on the upside of forecasts a bumpier recovery path lies ahead. The unemployment rate falling faster than expected will show slower improvement over the next year or two and annual wages growth will take time to lift to territory that will cause annual inflation to challenge consistently the top of the RBA’s 2 to 3 per cent target band.
Rising longer-term international and Australian bond yields this year so far say that the bond market is looking at stronger economic growth delivering higher inflation sooner than central banks are expecting. The RBA is saying explicitly that the bond market is wrong and unacceptably high inflation will not occur over the next year or so. The RBA is prepared to back its inflation view by buying more bonds whenever it feels that the bond market is pricing inflation risk inappropriately.
The RBA is also doubling up in the battle to contain rising bond yields by reinforcing the message that it is wages growth that matters when forecasting inflation and for the next year, two or three at least there will be sufficient slack in the labour market that make it unlikely that annual wages growth will rise above 4% y-o-y, the territory that wage growth would need to get to and stay above to drive annual inflation at 3% y-o-y and above.
In the latest set of RBA economic forecasts issued in the February Monetary Policy Statement the furthest forecast point for June 2023 has annual wage growth at 2.0% y-o-y and annual inflation at 1.75% y-o-y. These wage and inflation forecasts back RBA statements of no cash rate increases before 2024. Indeed, they imply no cash rate hikes for a year or two longer than 2024.
The issue is whether the RBA will need to revise higher its wage and inflation forecasts and at what point upward revisions warrant a change to guidance about the timing of the need to hike the cash rate?
The next quarterly Monetary Policy Statement is due in early May and there is already a need for upgrades to the February forecasts. In February, the RBA forecast December 2020 annual GDP growth at –2.0% y-o-y. The actual outcome in the early March data release was –1.1% y-o-y. The RBA’s February forecast for December annual wage growth at +1.25% was shy of the +1.4% outcome released just a week after their forecast. Looking forward to June 2021, the RBA’s February unemployment rate forecast at 6.5% is above the latest January reading, 6.4%, and the market consensus forecast 6.3% for February (data release on Thursday).
Already there is a case for upgrades to key RBA economic forecasts in May. Those upgrades may see the annual wage forecast for June 2023 increase to 2.25% from 2% in February and the annual inflation forecast lift to 2% from 1.75%. The increases in wage and inflation forecasts are small and not sufficient to cause a change in RBA guidance about timing a cash rate hike, at least not in May.
The problem is not with the small size of wage and inflation forecast upgrades but with the RBA repeatedly underestimating the strength of the economic pick-up and repeatedly upgrading economic forecasts. The RBA has upgraded forecasts in the past three quarterly Monetary Policy Statements. The May 2021 Statement will make it four in a row.
The repeated quarterly upgrades place the risk on the side of more increases to wage and inflation forecasts in quarterly Monetary Policy Statements in the second half of 2021. Those changes may imply a need to hike the cash rate before 2024.
There is also another potential problem of underestimation of wage growth relating to the relationship between the falling unemployment rate and what that means for the tightness of the labour market and wage growth. The RBA is assuming that that the unemployment rate consistent with full employment is nearer to 4% than 5% and still well below the current 6.4% unemployment rate. The economy still has labour market slack on this assumption, especially when those who are working less hours than they would like are added to the equation. However, economic changes during the pandemic may have caused the labour market to tighten more at higher levels of unemployment than has been the case in the past.
Covid-19 and the policy responses to deal with the consequences have altered the economy and its driving components. Some changes are temporary such as much increased household spending on goods rather than services reflecting restriction spending on items such as overseas travel and compensatory spending elsewhere. Some spending patterns may have changed permanently, such as more spending on housing and home offices. Some businesses need to lift employment quickly to meet sudden increases in demand. Some businesses are finding that that their traditional sources of labour have dried up. For example, overseas workers for seasonal farm work and skilled migrants in aged and health care services.
The pool of unemployed and under-employed labour will have some of the skills to fill jobs in demand in the post-Covid economic recovery, but there are signs in several industries of developing shortages of labour with appropriate skills. Wages may start to be bid up sooner in these industries. It is also possible that general wage pressure may develop at a higher rate of unemployment than has been the case in the past because of the greater difficulty matching available labour with the skills demanded in the current economic recovery.
For the next few months at least, the RBA will remain adamant that wage growth and inflation will be slow to rise and there is no case for a cash rate hike before 2024. Repeated upgrades to its economic forecasts, including its wage and inflation forecasts, mean that at some point the RBA will review its rate guidance. Our view is that the RBA will change its rate guidance next year with a first rate hike likely in 2023.