The Reserve Bank Board meets next week on February 1.
The Governor will be addressing the National Press Club on February 2 and the Bank will release its February Statement on Monetary Policy on February 4.
On January 20 Westpac surprised most analysts by forecasting that the first rate hike by the RBA will be announced at the August Board meeting.
The AFR released a “poll” of bank forecasters on the day of that announcement which showed: Westpac (August); CBA (November); ANZ (early 2023); NAB (mid 2023); and HSBC (late 2023) as the forecast dates for the first move by the various banks.
Westpac has also forecast that it is “almost certain” that the Board will announce it has decided to cease its $350 billion bond buying program at the February Board meeting.
The most significant part of the Statement on Monetary Policy will be the Bank’s revised forecasts, including GDP; the unemployment rate; inflation and wages.
In November, the Bank forecast that underlying inflation would be 2.25% in 2021 and hold at that level in 2022.
Wages growth was forecast at 2.25% by end 2021; 2.5% by end 2022; and 3% by end 2023.
It forecast that the unemployment rate would be 4.75% by end 2021; fall to 4.25% by end 2022 and 4% by end 2023.
As we discussed in our note on January 20 these forecasts are entirely consistent with the Bank’s “guidance” that it will not achieve its objectives of full employment (around a 4% unemployment rate); and “actual inflation sustainably within the 2–3% target range” until late 2023/early 2024.
The Governor has noted that wages growth around 3% will be necessary to sustain inflation within that band.
But, as we now know, the data flow is no longer consistent with the forecasts in the November Statement on Monetary Policy. Last week, after Westpac published its revised cash rate view, the unemployment rate printed at 4.2% for December (down from 4.6%).
And, of course, on Tuesday annual underlying inflation (trimmed mean) printed 2.6% for 2021, including a 1% rise in the December quarter. That result means that the Bank has achieved its inflation target for underlying inflation for the first time since 2014.
Global policy adjustments have also surprised. Back in November the general consensus was that the first rate increase from the FOMC would be late in the second half of 2022. This morning the US Fed Chairman confirmed that the first move can now be expected in March.
So, how might the RBA respond to these rapidly changing developments?
The Governor might feel somewhat uncomfortable with the rigid guidance he has stuck with throughout 2021.
As recently as December 16, in his last speech of the year, he noted that “In our central scenario the condition for an increase in the cash rate will not be met next year. It is likely to take time for that condition to be met and the Board is prepared to be patient”.
But it is unnecessary for him to feel this way.
After all, the Bank has not achieved its inflation target since June 2014 – more than two years before Governor Lowe was appointed.
We are currently experiencing the lowest unemployment rate since 2007!
And we expect that the GDP growth forecast for 2022 (which was 5.5% at the November forecast) will only be “shaved” by 0.5% (due to omicron uncertainties) to a very strong 5.0% in the February update. (Westpac agrees with such a strong GDP outlook – we are forecasting 5.5% growth in 2022).
The Bank should welcome reaching its objectives earlier than expected and forecast that this success can now be sustained in 2022 and 2023.
The first step should be to move the “trimmed mean” inflation forecast of 2.25% for 2022 to 2.5% and hold the 2.5% forecast for 2023 – essentially recognising that the key objective has now been achieved and can be expected to hold for the next two years.
Secondly, while the sharp fall in the unemployment rate to 4.2% might be seen to be subject to some statistical correction in the early months of 2022 we expect the RBA should be prepared to make a 4% unemployment rate forecast for the second half of 2022.
The area where we have not seen any recent data update is wages growth where the 2.1% growth rate for the Wage Price Index for the September quarter is still well below the Governor’s desired pace of 3%. Although, note that the 3% that has often been referred to in the Governor’s speeches is not a “hard” number as is the case with the inflation target.
Arguably ,the underemployment rate is the best measure of slack in the labour market.
In December we saw a sharp fall in the underemployment rate to 6.6% – a 13 year low (the lowest since the impact of the GFC) while business surveys and anecdotal evidence are pointing to rising wage pressures.
The 2022 forecast for growth in the Wage Price Index should be lifted from 2.5% to 3.0% although there is a risk that a cautious Governor might opt for 2.75% to discourage markets from sensing a degree of urgency in raising rates.
He could also point to ongoing COVID risks, with the recent omicron wave, seen to be a source of uncertainty around wages growth.
And to guard against any commitment to respond quickly to an unexpectedly strong print on the Wage Price Index for December (to be released late February) he could point out that considerable further evidence will be required before he would be convinced that Australia’s long period of wages underperformance has passed.
A Complication with the Forecasts
The key policy issue of our day is whether central banks have the tools and commitment to settle inflation back to their target ranges while holding the labour market near that full employment target.
As discussed we think that the RBA will forecast just such an outcome in 2023 and 2024 (in February the forecasts will be extended to June 2024).
But that key policy issue will be largely unresolved.
That is because the RBA adopts the convention of using market pricing for the interest rate path under-pinning the forecasting process.
While the current cash rate is 10 basis points markets are forecasting a terminal cash rate in 2024 of 2.25%. The profile largely assumes around 100 basis points of hikes in 2022; around 90 basis points in 2023; and 25 in 2024.
What we do not know from the RBA’s forecasts is whether the achievement of the policy targets over the forecasting period is CONTINGENT on the rate profile that is used in the analysis.
It may be that the RBA agrees with the markets’ target terminal rate and the issue at point is really only the urgency of the timing of the start of the tightening cycle. The RBA may be thinking that once the process begins it will be necessary to adopt some profile similar to the market’s current estimate to achieve stability in inflation while maximising employment.
If, for instance, the RBA’s forecasts showed inflation under shooting the target in 2023 and the unemployment rate rising then the implication would be that RBA believes current market pricing is too “heavy handed” to achieve the objective.
In many ways these issues are much more intriguing than the forecast path the Bank is likely to set out next week.
The RBA is likely to revise its forecasts to make them consistent with a rate hike later in 2022 rather than the current “late 2023/ 2004”. That will entail forecasting 2.5% underlying inflation and 4% unemployment rate in 2022.
Some “insurance” could be taken out by only going to 2.75% in the forecast for wages growth in 2022. But, remember, the official wages target is “a labour market to be tight enough to generate wages growth that is materially tighter than it is currently”- not a hard number so not quite reaching 3% in 2022 may not be enough to preclude a policy response.
Westpac is unlikely to see a reason to change its own forecasts on the basis of the deliberations next week.
Because the forecasts assume market pricing for the cash rate the real issue is whether the Bank , by implication, believes that the rate profile in the market will be necessary to settle the economy back at an equilibrium where inflation sits around target and the economy enjoys full employment.