Three data points, two Australian and one US, help to explain why upward pressure will continue to build on Australian borrowing interest rates. The Australian data points relate to the strong labour market and inflation close to lifting higher while the US data point relates to prolonged and now strong economic growth. The three taken together imply that US interest rates will continue to rise while Australian interest rates need to rise.
We wrote last week about the approaching squeeze in the Australian labour market and the June labour force report released last Thursday confirmed that growth in employment remains very strong. Employment rose by 50,900 in June a much stronger result than expected. The labour force participation rate rose to record high 65.7% – a mark that people previously outside the workforce feel very confident of finding work if they start looking – and the unemployment rate edged down slightly to just under 5.4%, a new 5-year low.
The strength of the June labour force report, especially when combined with evidence from record high job vacancies that employers are seeking many more employees point to the risk of quite a pronounced lift in wages especially in occupations where supply of suitably skilled workers is scarce. Strong employment growth is also helping to lift growth in household disposable income at a much faster pace than wages growth helping households to manage servicing payments on high household debt and leaving some leeway for stronger household spending too.
One misconception gaining hold among analysts is that high household debt and a fragile housing market will prevent the RBA from lifting the cash rate. That would be true if signs of soft economic activity were widespread, but at present signs of improving economic activity in Australia are proliferating and look set to counter by a wide and increasing margin the potential threats to growth from high household debt and softer housing activity.
The RBA is dealing with an economy starting to grow fast enough to cut in to what excess capacity there is. In the case of the Australian labour market remaining excess capacity is diminishing rapidly with every strong monthly labour force report.
The second key data point, Australian inflation, will be updated for Q2 on Wednesday this week. If the market consensus forecast is accurate, the Q2 CPI will lift 0.5% q-o-q raising annual headline CPI inflation to 2.2% y-o-y from 1.9% in Q1. The two main “underlying” inflation reading, the trimmed mean and weighted median, are both expected to come in around 0.5% q-o-q, 1.9% y-o-y.
If the Q2 inflation readings come in close to consensus inflation still looks quite benign, even though the headline annual CPI reading will be inside the RBA’s 2-3% target band; the highest annual inflation reading since Q3 2014; and more than double the 1.0% y-o-y low-point inflation reading recorded in Q2 2016. In short with very little pressure so far lifting annual inflation it will if the consensus forecast is correct have lifted quite significantly over the past two years and moved above 2.0% y-o-y.
The problem is that inflationary factors are starting to build. Producer prices are lifting around the world (and will lift much more in a trade war) feeding through to higher prices for goods imported in to Australia. A noticeable softening of the Australian dollar exchange rate will also serve to push up import prices. The longer the RBA holds out before lifting the cash rate the greater the risk of a much softer Australian dollar adding even more upward pressure on import prices. While Australian wages growth is not yet presenting a higher inflation threat, it is only a matter of time before it becomes one if the labour market continues to tighten in the way that it has been.
The labour market data released last week and the Q2 CPI due this week are both likely to make it plain that the current 1.50% cash rate is too low and will need to be adjusted upwards before long.
Very strong US economic growth is another factor that means that Australian borrowers will continue to face rising borrowing interest rates regardless of what happens to the local cash rate. The advance reading of US Q2 GDP is due for release on Friday and the consensus forecast is that annualised growth jumped to 4.2% in Q2 from 2.0% in Q1. Just about every component of US demand quickened in Q2 and that should reflect in the Q2 GDP report. The long US economic expansion has reached a point of exposing capacity shortages in several sectors. US annual CPI inflation has accelerated to 2.8% y-o-y and is threatening to push well above 3%.
The US Federal Reserve (Fed) has made it plain that it will continue to lift its funds rate. The most recent 25bps hike in June was the seventh in the current series and the funds rate is now at 2.00%. The Fed is promising two more 25bps hikes by the end of 2018 and at least another three hikes in 2019. For Australian lenders with their substantial and growing offshore funding programs (much as they might like to fund more onshore Australian households are massive net debtors making net funding from the Australian market alone impossible) the Fed’s rate hikes and their influence on short-to-medium term interest rates in the US are making Australian funding in offshore markets increasingly expensive.
Higher offshore funding costs are likely to force Australian lenders to lift their interest rates from time-to-time. The RBA is unlikely to try and offset this upward interest rate pressure by reducing its cash rate quite simply because higher Australian borrowing interest rates are appropriate for an economy growing to the point where inflationary pressure is starting to build. Indeed, depending upon the three key data points discussed earlier it is possible that higher offshore funding costs could be reinforced by an RBA rate hike over the next few months.