In each quarterly Monetary Policy Statement since February last year the RBA has revised upwards its “Baseline” Scenario GDP growth forecasts and downward its unemployment rate forecasts. It has also made modest upward adjustments to its forecasts of annual wages growth and inflation although these remain low at 2.0% and 1.75% respectively in the RBA’s latest and furthest date forecasts for June 2023. The low mid-2023 wages and inflation forecasts enable the RBA to say that it will not increase the current 0.10% cash rate for at least three years. But those modestly revised low wages and inflation forecasts seem at odds with the big revisions to GDP growth and unemployment.
The RBA Board meeting last week concluded, “The Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market. The Board does not expect these conditions to be met until 2024 at earliest”.
At face value the statement is unambiguous, the 0.10% cash rate will stay for the next three years based on the RBA Board’s current view about the labour market and inflation. That view is based firmly on the latest staff economic forecasts provided by the RBA. If the RBA’s economic forecasts continue to change as they have over the past year – a series of upward revisions to GDP growth and all that is contingent including higher employment growth, lower unemployment rate, higher wages growth and inflation – the RBA Board’s view will change and the timeline for a higher cash rate could come in to 2023 or even 2022.
It is not just future changes to the RBA’s economic forecasts that may change the RBA Board’s cash rate guidance. The latest set of RBA economic forecasts raise questions about whether inflation may lift more quickly than forecast.
Between the November 2020 Monetary Policy Statement and the February Statement the RBA’s near-term forecasts for June 2021 annual GDP growth are revised upwards to 8% y-o-y from 6% y-o-y; employment growth revised upwards from 3.0% y-o-y to 5.75% y-o-y; and the unemployment rate revised downwards from 7.5% from 6.5%.
Forecasts relating to national income in June2021 are revised more substantially with annual growth in real household disposable income (set to fall with government support payments stepping down) revised from –6.0% y-o-y to –3.0% y-o-y and the terms of trade (export prices relative to import prices) revised from -5.0% y-o-y to +12.5% y-o-y.
The revised RBA forecasts point to economic activity accelerating rapidly in the first half of 2021, the type of economic conditions that can result in supply friction and shortages driving up prices. Some evidence of this starting to occur is showing in higher house prices, higher car prices and higher prices for domestic travel.
Yet the RBA’s latest wages and inflation forecasts only show slow, modest upward pressure. Forecast annual wages growth for June 2021 is 1.0% y-o-y, unchanged from the November forecast. While annual inflation has been revised upwards to 3% from 2.25% in November but then reduces to 1.5% through to end 2022 (November forecast 1.25%). Beyond June 2021 the RBA has lifted its annual wages growth forecast but only a quarter percentage point compared to its November forecasts to 1.5% y-o-y for December 2021, 1.75% in 2022 and 2.0% for June 2023.
The RBA does not see wages growth picking up significantly until the unemployment rate falls below 5%. The latest forecasts show the unemployment rate falling more quickly than expected in November but still sitting at 5.25% in June 2023.
Two issues are raised by the RBA’s forecasts and the relationship they see between the unemployment rate and wages growth. The first is the RBA’s history of upward revisions to annual employment growth and downward revisions to the unemployment over the past year. If the trend of upward revisions continues this year it is only a matter of a quarter or two before the RBA has the unemployment rate falling below 5% by June 2023 and wages growth running much higher than 2%.
The second issue is whether the RBA is right to continue to assume that the unemployment rate and wages growth respond slowly to faster GDP growth? Labour market dynamics in the current and future Covid-safe economy look different compared to the pre-Covid-19 economy. Unemployed resources are likely to take time and training to adjust and frictional pressure potentially escalating wages may develop at a higher unemployment rate than has occurred in the past. In short, the labour market may become tight causing higher inflation at a higher unemployment rate than has been the case in the past.
For the time being the RBA continues to base its views about the labour market and its relationship to inflation on the pre-Covid-19 world where long-term disinflationary forces ruled and ensured that economic recovery phases took time to lower unemployment and placed little upward pressure on wages.
The post-Covid-19 world is shaping up differently. Economic globalisation, powerfully holding down international production costs and prices over recent decades, is a diminished force. Government stimulus spending has jumped to a scale not seen since World War II. Central banks are monetising Government debt on a massive scale. Even the RBA is promising on the latest $100 billion extension of its bond buying program to buy government bonds at a pace $1.5 billion a week more than the Government is issuing.
These substantial changes raise questions about whether it is reasonable to assume that wages growth will respond to falling unemployment in the same way that it did in the more clearly disinflationary environment pre-Covid-19.
It will take time to see whether the RBA must keep upwardly revising its economic forecasts and/or the relationship between the unemployment rate and wages growth has changed. We do not expect the RBA to change its views about wages and inflation quickly. But repeated sharp upward revisions to GDP growth and reductions in forecast unemployment unrequited in commensurate upward revisions to wages growth and inflation point to a change in view at some point. We see the cash rate unchanged at 0.10% through 2021 but doubt whether the RBA can do as it is proclaiming and hold it unchanged through to 2024.