Cash Rate to Stay at Historic Low, But Not for Much Longer
There is no new data on Australian CPI inflation, the most recent reading being 3.5% (headline, annual) and 2.6% (trimmed mean, annual) in the December quarter of 2021, above (within) the RBA’s official target band of 2-3%. GDP grew by 3.4% in the December quarter of 2021, exceeding market forecasts of around 3%. The RBA Shadow Board’s verdict is, once again, strongly in favour of keeping the cash rate steady at its historic low; it is 86% confident that this is the appropriate policy setting. However, at longer time horizons the Shadow Board’s consensus is shifting towards a tightening of the monetary stance.
The official ABS unemployment rate dropped from 4.2% in January to 4% in February, and it is projected to fall further. Youth unemployment, however, was unable to break below 9% in the same period. Total employment grew by more than 75,000, with full-time employment actually increasing by an impressive 122,000. The increase in employment and fall in unemployment coincide with a rise in the labour force participation rate of 0.2 percentage points, to 66.4%. The underemployment rate remains within the 6.5-7% range. Monthly hours worked increased by nearly 9%, which is a very significant improvement. There is no new data on (nominal) wages growth, which will be a key variable to look at in the coming months.
The Aussie dollar found strong support near the 70 US¢ mark and has recently climbed to 75 US¢. Matching the global trend, yields on Australian 10-year government bonds extended their climb, from a recent low of approx. 1.65% three months ago to 2.84% on the last day of March. Yield curves retain their normal convexity. Interest rate spreads have widened for shorter maturities: for short-term maturities (2-year versus 1-year) the spread is now 77.6 points; in mid-term versus short-term maturities (5-year versus 2-year) the spread is 78.8 bps, whereas for higher-term maturities (10-year versus 2-year) the spread fell to just below 100 bps. In the Australian share market initial losses following the invasion of Ukraine were recovered, a picture replicated elsewhere in the world. The S&P/ASX 200 stock index is again trading just below 7,500, some 500 points above its low one month ago.
The pre-election federal budget announced earlier this week is expansionary, as widely expected, including tax cuts and transfers to boost household disposable incomes as well as substantive spending programs on infrastructure, healthcare, and defence. This is not expected to increase the fiscal deficit in the coming fiscal year, a reflection of strong revenue growth, but it does add to overall inflationary pressures in the domestic economy.
Globally, the early jitters precipitated by the Ukraine war appear to have subsided a little. However, considerable downside risks for the global outlook remain, both due to Covid-19 and due to geopolitical forces. Severe bottlenecks, e.g. in the semi-conductor industry, will take a while to unblock, and energy and food prices can be expected to remain high and volatile. There is substantial disagreement among economists and policy makers about the likely duration of current inflationary pressures. The Federal Reserve has, after US inflation recorded a 40-year high, raised the federal funds rate and it has clearly indicated this is the beginning of a longer tightening cycle. The ECB may follow, albeit with a delay and less aggressively. So far, the RBA has remained sanguine about domestic inflation, arguing that it is transitory, but this view will need to be re-evaluated with new price and wages data coming out mid-year.
Australian consumer confidence dropped a little; the Melbourne Institute and Westpac Bank Consumer Sentiment Index fell from 101 to 96.6 in March. Retail sales growth is holding up, coming in at 1.6% in January and 1.8% in February, month-on-month. NAB’s index of business confidence, which tends to be volatile, continued its rebound, from -12 in December and 3 in January to 13 in February. The services and manufacturing PMIs both improved by around 3 points. The capacity utilization rate increased yet again by close to a full percentage point, to 82.51% in February. Mixed news comes from the Westpac-Melbourne Institute Leading Economic Index, considered a pretty reliable cyclical indicator for the Australian economy, which contracted by 0.2% year-on-year in February 2022, and the IHS Markit Australia Composite PMI, which, with a reading of 57.1 in March (a 10 month high), is strong. Overall, these indicators are pointing to a healthy expansion.
The official cash rate target has been at the historic level of 0.1% for 16 months. The Shadow Board’s conviction to keep the overnight interest rate at this historic low strengthened marginally. It attaches an 86% probability that “no change” is the appropriate policy (up from 83%) and a 13% probability that an increase is appropriate (down from 17%).
The probabilities at longer horizons are as follows: 6 months out, the confidence that the cash rate should remain at 0.1% weakened substantially, from 51% in March to 33% in the current round; the probability attached to the appropriateness of an interest rate decrease remains unchanged at 0%, while the probability attached to a required increase correspondingly rose from 49% to 67%. One year out, a similar picture emerges. The Shadow Board members’ confidence that the cash rate should be held steady dropped again, from 33% in March to 13% in this round. The confidence in a required cash rate decrease, to below 0.1%, is 0% (unchanged) and in a required cash rate increase 88% (67% in March). Three years out, the Shadow Board attaches a 7% probability that the overnight rate should equal 0.1% (down two percentage points) and a 93% probability that a rate higher than 0.1% is optimal (up three percentage points). The range of the probability distributions widened: for the 6-month horizon it extends from 0.1% to 1%, for the 12-month horizon from 0.1% to 2% and for the 3-year recommendation from 0.1% to 4%.
