RBA’s Phil Lowe flags late 2022 interest rate rises

RBA Governor Phil Lowe has just delivered a speech entitled “Recent Economic Developments”, where he pushed back against predictions of imminent rate rises, but noted that “it is plausible the cash rate will be increased later this year”.

Below are extracts of the speech, with key points highlighted in bold:

The journey towards full employment

At the start of last year, our central forecast was that the unemployment rate would now be at 6 per cent. Yet over recent months, the unemployment rate has been 4.2 per cent and underemployment has fallen to the lowest rate in more than a decade (Graph 3).

We expect this improvement in the labour market to continue… Our central forecast is that the unemployment rate will fall to below 4 per cent over the course of this year and remain there next year. The last time that the unemployment rate was that low was almost half a century ago (Graph 4). If we reach this milestone, it would be a significant achievement.

This raises the question of what constitutes full employment in Australia in the early 2020s. We don’t have a predetermined answer here – we are being guided by the evidence, particularly the outcomes for wages and prices. There is a lot of uncertainty surrounding estimates of the Non-Accelerating Inflation Rate of Unemployment (NAIRU), and our estimates have trended lower over recent years as more evidence has become available. I hope, and expect, that a period of sustained economic growth can further lower estimates of the unemployment rate associated with full employment. But time will tell…

Inflation

After many years in which concerns about high inflation were at the periphery of the radar screen, they have now moved to the centre in a number of countries. This is especially so in the United States, where the CPI increased by 7½ per cent over the year to January, which is the fastest rate in 40 years. Inflation rates in the United Kingdom, Germany, Canada and New Zealand are also at their highest in decades (Graph 5)…

Headline inflation here is 3½ per cent, less than half the rate in the United States. In underlying terms, inflation is running at 2.6 per cent. This is the first time in more than seven years that it has been above the midpoint of medium-term 2 to 3 per cent target band…

The first is the different developments in the gas and electricity markets. In the United States, household gas prices are up by nearly 25 per cent over the past year and electricity prices are up by more than 10 per cent (Graph 6). In contrast, the prices that Australian households pay for energy have risen only modestly. Our gas and electricity markets are not closely connected with those in the rest of world and the increased capacity from wind and solar generators has put downward pressure on wholesale electricity prices.

A second factor is the different behaviour of goods prices. In the United States, goods prices (excluding energy) are up by 9 per cent over the past year. In Australia, they are up by 3 per cent (Graph 7). In the United States, there was a very strong surge in demand for goods during the pandemic and firms had trouble meeting this due to supply-chain problems and, in some areas, a shortage of workers. The result has been a big increase in prices. The same general dynamic has been at work in Australia, but the surge in demand for goods has been less pronounced here and the pandemic has not had the same effect on the availability of workers.

A third and more enduring factor is the different trends in labour costs. In the United States, and the United Kingdom, wages are rising much more quickly than they were previously (Graph 8). In contrast, in Australia, but also in Japan and some European countries, wages are increasing at a similar rate to before the pandemic. One factor contributing to these differing experiences is the different trends in labour force participation. In the United States and the United Kingdom, labour force participation is still below its pre-pandemic level. In contrast, in Australia, we are near record highs in terms of participation…

The point I want to make here is that while there is a common thread to inflation stories across many economies, there are important differences as well. These differences are relevant to the setting of monetary policy, to which I will now turn…

Monetary policy…

Since the onset of the pandemic, the Board has said that it will not increase the cash rate until inflation is sustainably in the 2 to 3 per cent target range. It has indicated that it wants to see evidence that inflation will be sustained in this range, rather than simply be forecast to do so. This focus on outcomes and evidence reflects both the uncertain times we are living in, which has made forecasting more difficult than usual, and the persistent undershooting of the inflation target over earlier years.

The recent lift in inflation has brought us closer to the point where inflation is sustainably in the target range. So too have recent global developments. But we are not yet at that point. In underlying terms, inflation has just reached the midpoint of the target band for the first time in over seven years. And this comes on the back of very large disruptions to supply chains and distribution networks, some of which are still expected to ease. It also comes at a time when aggregate wages growth is no higher than it was before the pandemic, which was associated with inflation being persistently below target.

In these circumstances, we have scope to wait and assess incoming information and see how some of the uncertainties are resolved. We can be patient in a way that countries with substantially higher rates of inflation cannot.

There are two issues, in particular, that we are paying close attention to. The first is the persistence of supply-side price shocks and the extent to which developments in Ukraine add to these supply-side inflation pressures. The second is how labour costs in Australia evolve.

Prior to the war in Ukraine, there was some evidence that the supply-side issues in the global economy were gradually being resolved (Graph 9). Delivery times had shortened a bit, global car production was increasing again and the prices of semiconductors had come off their peaks. Businesses were also responding with new investment and changes in processes to ease capacity constraints. These developments were providing a basis for expecting that supply-side inflation pressures would ease over time, both globally and here in Australia.

But, now, the war in Ukraine and the sanctions against Russia have created a new supply shock that is pushing prices up, especially for commodities. This new supply shock will extend the period of inflation being above central banks’ targets. This runs the risk that the low-inflation psychology that has characterised many advanced economies over the past two decades starts to shift. If so, the higher inflation would be more persistent and broad-based, and require a larger monetary policy response. At the moment, financial market pricing suggests that CPI inflation will decline from its current high rates in the North Atlantic economies to around 2 per cent without real interest rates ever going into positive territory. A shift in inflation psychology would challenge this view, so this is a critical issue.

The second issue we are watching closely is the evolution of domestic labour costs. The latest data confirmed that aggregate wages growth remains modest. The Wage Price Index (WPI) increased by 2.3 per cent last year, with the broader measure including bonuses increasing by 2.8 per cent (Graph 10). The national accounts measure of average hourly earnings increased a bit faster than this at 3.3 per cent. This measure is more volatile than the WPI as it captures changes in the composition of employment, which have been large during the pandemic. There are certainly pay rises that are much larger than 3 per cent taking place for some jobs, but the evidence is that most working Australians are still experiencing base wage increases of no more than 2-point-something per cent. This is also consistent with what we are hearing through our business liaison program.

The RBA’s central forecast is for growth in aggregate labour costs to pick up further as the labour market tightens. This pick-up is likely to be gradual, though, given the multi-year enterprise agreements, the annual review of award wages and public sector wages policies.

There are, however, uncertainties about the future growth of labour costs. This is partly because we have no contemporary experience of a national unemployment rate below 4 per cent. The closest experience we have is that in the years leading up to the pandemic some of the larger states had unemployment rates around 4 per cent and wages growth hardly moved. It is also unclear, at this stage, what effect the opening of the international borders will have on the balance between supply and demand in the labour market. There is also the question of how wages respond to the current higher rates of headline inflation. There is a risk if these higher inflation rates are sustained as a result of a sequence of negative supply shocks, that wages growth picks up more quickly than forecast as workers seek compensation for the higher inflation.

In this uncertain environment – and with the starting points for wages growth and underlying inflation in Australia – we can take the time to assess the incoming information and review how the uncertainties are resolved. Given the outlook, though, it is plausible that the cash rate will be increased later this year.

I recognise that there is a risk to waiting too long, especially in a world with overlapping supply shocks and a high headline inflation rate. But there is also a risk of moving too early. Australia has the opportunity to secure a lower rate of unemployment than has been the case for some decades. Moving too early could put this at risk. There are benefits to the economic welfare of Australia of a period of relatively steady growth in which people get jobs, have training and develop skills. This is one path to sustaining a lower unemployment rate than was thought possible just a short while ago – not as low as was thought possible back in 1963, but lower than was thought possible just five years ago.

I want to finish with the point that it is only possible to achieve a sustained period of low unemployment if inflation remains low and stable. Recent developments in Europe have added to the complexities here. The Reserve Bank will respond as needed and do what is necessary to maintain low and stable inflation in Australia.

The above is basically a rehash of the well trodden point that the RBA won’t lift the cash rate until it sees evidence that wage growth has risen above 3%, which is unlikely to be achieved until late this year.

In turn, Phil Lowe has basically thrown a wet blanket over economists tipping rate rises in May or June. It is content to take a ‘wait-and-see’ approach.