Markets are today busily repricing the prospects for interest rate rises around the world. This is being driven by the vaccine-led post-COVID recovery, ongoing monetary and fiscal stimulus and rising supply-side inflation associated with bottlenecks and runaway demand for goods while services are suppressed by lack of mobility.
Yesterday TD Securities argued that the RBA is not immune to these trends and the market is right to fight it on its outlook for no interest rate rises before 2024. Is it right?
First, let’s check in on Australian bond curves. The short-end of the curve is being sat upon by the 300 pound gorilla at Martin Place but the long end of the curve has steepened dramatically as better growth and inflation prospects are priced in:
Second, spreads to the US have been relatively muted, not moving materially since Australia’s better virus performance became apparent through 2020:
I would summarise this as RBA success. It is keeping the yield spread to the US from blowing out despite very high term of trade. This is weighing on the Australian dollar relative to the counter-factual.
One might see holding down the AUD in such circumstances as inflationary given we’re entering an asset price boom which will doubtless lift domestic demand, further fueled by the national income boom.
However, there are some important factors weighing against this conclusion, especially as the recovery expands.
Terms of trade booms in Australia are not what they used to be because the income used to permeate the economy via better budget outcomes and tax cuts, higher stocks and rising wages as miners invested. Now, it is only the second of those that matters terribly with deep deficits to repair and plenty of mine capacity.
We already saw this play out before COVID.
So, that leaves the rest of the economy fighting a higher Australian dollar than it can manage. This will be seen in harm to all kinds of tradable sectors but most importantly education and tourism which will struggle to rebound post-COVID, even before we consider any new blockades from China.
Any rise in inflation will therefore hang on domestic demand. It will be strong enough to generate some inflation. But, again, there are powerful mitigating factors which include huge fixed-asset overcapacity in all service sectors owing to work from home and crushed immigration.
This may repair itself somewhat with vaccines and increased mobility plus a resumption of population growth. But that, as it is currently configured, will also crush wages so is self-defeating for inflation.
The point is that the Australian inflation outlook is not very strong in absolute terms nor relative, and it will be highly dependent upon rising house prices as it is.
Returning to the point of this post, that leaves the RBA rather snookered in terms of achieving its freshly minted much more aggressive inflation goals. It won’t be in any rush to lift rates on that basis alone. But it also has macroprudential tools for house prices to work with these days so when the time does come those will be used first. And, given how central house prices will be to the recovery, the spillovers over to the wider economy may be considerably more potent than the last cycle.
I can see the RBA not hiking until 2024. Indeed, I see it easing more before them via a pivot to the long-end of the bond curve with even more QE.
Fight it if you dare!