The RBA is aiming to drive Australia’s unemployment rate below 4.0% and believes that the unemployment rate consistent with longer-term non-accelerating inflation holding inside its 2-3% inflation target band is around 3.75%. In effect, a 3.75% unemployment rate constitutes full-employment, where annual wage growth is higher than it is currently, but not high enough to push annual inflation sustainably above target.
In the latest set of economic forecasts from the RBA issued in the February Monetary Policy Statement the unemployment rate falls to 3.75% in December this year and then stays at that rate through the remainder of the forecast period to June 2024. Annual wage growth increases slowly from 2.2% y-o-y currently (Q3 2021 last reading) to 2.75% in December 2022; 3.0% through 2023; and 3.25% in the first half of 2024.
On the basis of these forecast labour market conditions, above 3% forecast annual inflation in the near term (peaking at 3.75% for the CPI and 3.25% for the trimmed mean in June this year) subsides to 2.75% for both through 2023 and the first half of 2024. Annual inflation is consistently inside target band through 2023 and the first half of 2024, albeit towards the top of the band.
If labour market conditions and inflation pan out according to the latest RBA forecasts, the RBA can read through the current upward blip in inflation before starting to lift the official cash rate from its current 0.10% “emergency low” setting. But at some point, inflation travelling inside target band still requires a higher interest rate setting to prevent it accelerating through the top of band.
The latest economic forecasts from the RBA imply the possibility of an official cash rate hike late in 2022 and if not then, the near certainty of a rate hike in 2023. There will also be a series of rate hikes that over a period of time will take the cash rate up to a “neutral” level consistent with real economic growth that maintains full-employment with inflation within target band. The “neutral” cash rate is likely to be around 2% to 2.5%.
We question several aspects of the RBA’s forecasts. The first question relates to the RBA’s unemployment rate forecasts. Job vacancies and employment, even with the temporary Omicron set-back, are rising fast enough to push the unemployment rate down further and more-quickly than the RBA is forecasting.
The latest January labour force report is due this Thursday. The survey was taken in the first two weeks of January at the height of the Omicron wave and seems likely to show relatively small set-back in employment (market consensus forecast -15,000 after a 64,800 increase in December) with the unemployment rate steady at 4.2%. Next month, the February labour force report will reflect post-Omicron peak conditions with spending in the economy rebounding sharply adding to the already strong demand for labour. A sizeable increase in employment is likely probably taking the unemployment rate below 4%.
The March and April labour force reports look set to register further employment gains pushing the unemployment rate much lower and probably below 3.75%. If a 3.75% unemployment rate is consistent with “full-employment” the push into “over full-employment” territory means that the most stretched parts of the labour market will try and obtain labour from other parts of the labour market by driving up wages.
There is a possility that more labour supply can be teased out from a lift in the labour force participation rate, but that rate is already at a near record high above 66%. Another possibility is foreign workers. The internationational borders are open again for most of Australia and while over time the flow of international workers may rebuild to pre-pandemic levels the initial flow is proving to be slow and not matching the skill set needed for the sectors where labour shortages are most acute. In time, that may change but too late to alleviate the near-term problem of labour market shortages.
A second question we have with the RBA’s latest forecasts is that if we accept the likelihood that the unemployment rate will not stop falling magically at 3.75% and will drive down through that level in the next few months it is near impossible to accept that wage growth will lift glacially slowly as the RBA is forecasting. Yes there is slow wage growth inertia in some parts of the labour market subject to public sector pay rise caps and muli-year enterprise bargaining agreements but that inertia is starting to be challenged with a rising number of pay disputes in the public sector and latest enterprise agreements incorporating 4% and greater pay increases in the first year.
In parts of the private sector experiencing need to entice labour or hold on to the workers they have, larger pay increases are becoming more common. The latest Q4 2021 wage price index is due next week. In Q3, the quarter-on-quarter increase was 0.6% giving a year-on-year rise of 2.2%. In Q4, another rise of 0.6% q-o-q would elevate annual wage growth to 2.3%, but the risk is that the quarterly increase will be greater. The Q1 2022 wage price index is likely to be materially bigger, around 0.9% q-o-q or higher. That would be sufficient to push annual wage growth up above 2.7% y-o-y. In short, annual wage growth in Q1 2022 is likely to be where the RBA is forecasting it will be in December 2022.
By mid-May, the RBA is likely to have to hand data showing the unemployment rate pushing down through the “full employment” level and wage growth faster than forecast in February. It is also likely that the Q1 CPI and underlying inflation readings will be consistent with annual readings testing 4% y-o-y by June 2022. We see the RBA with sufficient reason to start hiking the cash rate by May, but it may still delay until August. Either way, interest rate hikes are coming this year and the best clue to when the first hike will be is the unemployment rate marking down to 3.75% and lower.