RBA’s ‘narrow path to achieving a soft landing’ getting narrower
RBA’s Statement on Monetary Policy points to rising concerns around domestic inflation pressures.
The Reserve Bank has released its February Statement on Monetary Policy (SoMP). The highlight of these Statements is usually the Bank’s revised forecasts for growth, unemployment and inflation. However, this time around it was the more detailed picture around underlying inflation and wages that was of most interest. And on this, the Statement does show a notable shift, both indicators now expected to track above 4%yr in 2023 and wages growth to remain around 4% in 2024. While that was in line with our priors, it’s a troubling prospect for a central bank seeking to return inflation to the 2-3% target band. Aside from forecast changes, the SoMP also provides important colour around the Bank’s views and the messages coming via its liaison programme, both of which are tending to underscore the more hawkish tone present in the Governor’s decision statement earlier in the week.
That decision statement had already given away most of the key points from the Bank’s latest forecasts, namely: “CPI inflation to decline to 4¾ per cent this year and to around 3 per cent by mid-2025”; “GDP growth … to slow to around 1½ per cent over 2023 and 2024”; and “the unemployment rate to increase to 3¾ per cent by the end of this year and 4½ per cent by mid-2025” – all of which were largely unchanged from November.
Note that this is despite some slight shifts in the ‘conditioning assumptions’ used by the RBA in its forecasts – a peak cash rate of 3¾% rather than 3½% (based on the market economist forecasts and market pricing); an AUD at US$0.69 rather than US$0.64; and crude oil prices at US$82/bbl vs US$89/bbl. Note also that the RBA’s forecast horizon has also been extended out to June 2025.
While the central case view was largely unchanged, the RBA did make some notable tweaks to the it’s more detailed forecasts.
On inflation, the upside surprise on annual ‘trimmed mean’ inflation in Q4 (6.9% vs the RBA’s forecast 6.5%) led the Bank to lift its 2023 track, underlying inflation now holding at 6.2%yr in H1 and only easing back to 4.3%yr by December (vs previously forecast to track back to 3.8%yr). Aside from the starting point, the RBA also cited “second-round effects from higher energy prices” and a pick-up in domestic labour cost growth as factors lifting the view here.
Wages are quickly becoming the Bank’s central concern. Back in November we noted that the RBA’s 3.9%yr forecast for wages growth in 2023 looked underdone compared to our own forecast peak of 4.5%yr. The February SoMP has materially closed the gap, the RBA now forecasting a lift to 4.2%yr by year-end, holding at 4%yr in 2024. This was directly in line with our expectations going into the Statement.
That said, our broader views on the inflation outlook are now considerably more ‘constructive’ than the Bank’s. Westpac expects both headline and underlying measure of inflation to track back to a sub-4% annual pace by year-end with a larger deflationary pulse from supply-side factors showing through (including lower fuel prices, which the RBA’s convention assumes hold flat). We have already observed some encouraging supply-side developments in the US, particularly as they affect fuel, food, energy, goods, and building costs.
On the growth outlook, the unchanged view for 2023 and 2024 reflects a slightly weaker picture around momentum in the second half of 2022 (mainly around consumer spending but also dwelling investment and public demand), offset by a stronger outlook for population growth (now assumed to track in line with pre-COVID average pace). Notably consumer spending is seen as having moderated in the December quarter mainly due to the impact of higher prices on purchasing power rather than higher interest rates on household disposable incomes.
Interestingly the bank continues to sound relatively comfortably on the capacity of the mortgage belt to absorb interest rate rises. Based on cash rate rises to date, it projects scheduled mortgage payments to reach 9½-9¾% of household disposable income by the end of 2023, a similar level to total payments (principal, interest and excess payments) made through 2022. The accumulated ‘excess savings’ buffer across the wider household sector is also now estimated at just under $300bn with $120bn of this sitting in mortgage offset accounts.
A box-story ‘side-note’ in the SoMP also sends a more nuanced message around the ‘cash flow’ channel of interest rate rises. High household debt and the higher prevalence of variable rate and shorter-duration fixed term mortgages means this channel of policy tightening operates more quickly in Australia compared with most other advanced economies. However, the evidence suggests that policy more broadly (including effects through other channels) is not any more potent in Australia than elsewhere. While this has potentially chilling implications for how far policy rates may need to rise, it does not seem to be a view that is framing the Bank’s policy decisions.
Over five pages of the SoMP is dedicated to coverage of feedback from the RBA’s detailed business liaison program, which looks to be having a significant bearing on the Bank’s views. Key take-outs include: “some goods-related firms implemented fewer and smaller price increases over recent months than earlier in 2022 and expect price growth to slow further over coming quarters”; “… labour cost pressures generally increased as wages growth picked up over the December quarter” ; “Firms … expect wages growth to stabilise around 4 per cent in coming quarters” ; “… around half are looking to expand headcount”; “Around one-third of private sector firms reported wage increases above 5 per cent in the December quarter”.
Those comments feed directly into the Bank’s concerns around inflation expectations, which look to have been elevated slightly. The Overview section of the SoMP largely reiterates the messages from the Governor’s decision statement but gives more prominence to inflation expectations and their link with inflation psychology. Specifically, it observes that: “Longer term inflation expectations and wages growth in Australia have so far remained consistent with the inflation target. It is important this remains the case. That said, domestically sourced inflation and wages growth are both picking up. Given the importance of avoiding a price-wage spiral, the Board will continue to play close attention to both the price-setting behaviour of firms and the evolution of labour costs in the period ahead.”
Conclusion
The RBA has already described what it sees as a “narrow path to achieving a soft landing” in the economy. The February SoMP suggests this path is becoming even narrower with domestic inflation pressures coming to the fore and looking both stronger and more persistent, especially with respect to the labour market. Westpac remains comfortable with the view we expressed in October that the cash rate is likely to peak at 3.85%, entailing a further 0.25% increase in March and a final 0.25% increase at the May Board meeting. While we think this and a sharp disinflationary effect from easing supply-side pressures will be sufficient to bring inflation back under control, the tone of this latest RBA commentary suggests the Board may see itself with less scope to pause and potentially more work to do.
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