The RBA Observer On hold this month

PRESS RELEASE

The RBA Observer On hold this month

RBA will be on hold this month as it waits for confirmation of rising inflation with the Q2 CPI print in late July speeches from RBA officials during the month reaffirmed their tightening bias but recent weaker labour market data and global indicators mean the risk is for a more elongated pause

Waiting for Godot Much like Beckett’s protagonists who spend the whole play waiting for the arrival of a character named Godot, we continue to wait for an RBA hike. Arguably the RBA has had a tightening bias since its last hike in November 2010 and true, the bias has waxed and waned a little, but it was reaffirmed in early May and again in recent speeches. Now, just as it had looked ready to go, the domestic and global data have weakened a bit.

Of course in Beckett’s play, Godot never arrives. And that is certainly what markets are pricing – 3bp of cuts (yes, cuts!) are currently priced over the next year. Why? Global jitters, particularly due to sovereign debt problems in Greece and the US, mean the market has been straddling a low probability catastrophic financial event, which would see the RBA cut aggressively, and the higher probability of further rate rises. This leaves average pricing for cuts. We saw a similar development during the Japan disaster earlier this year. But keep in mind it is not historically unusual for markets to price up to 25bp of cuts (as it had early this week) and for the next move to still be a hike.

So will rate rises eventually come? Will Godot arrive? We think so, and are still expecting the next move to be in August, after an elevated CPI reading on 27 July. Although recent weaker domestic indicators – particularly softer employment growth and business conditions – as well as more subdued global conditions, provide some risk to this timeframe. Nonetheless, we think hikes will be forthcoming and give little credence to the argument that the next move is down. Why? Because the mining investment boom is a massive multi-year story and to stop it there would have to be a significant rout in iron ore and coal prices, which seems unlikely, given continued Chinese demand.

RBA officials seem to agree. Speeches during the month reaffirm the view in the May quarterly official statement that rates will need to rise by more than 50bp over the next 12-18 months to contain inflationary pressures. They expect to have to hike ‘at some point’, but have pretty much told us they’ll need the Q2 CPI print first – so August then.

Greek and other types of "tragedies" Financial market news has been dominated by Greek sovereign debt concerns during the past month.

Our perspective on the likely impact of these events on Australia remains the same – limited. Exchange rate and bond markets have been buffeted, and we could see further movements, but the direct macroeconomic linkages are weak. It would take significant contagion to other parts of Europe and the world to affect Australia, with the likely channel being bank cost of funding. But even here, the effect would be much less than the GFC, as banks have been shifting their funding towards deposits and away from offshore wholesale markets – now 20 cents in the dollar, down from 30 cents four years ago – and lengthening the tenor of their offshore issuance. The GFC has also given local banks four years to prepare for a potential repeat of liquidity problems, during which they have shored up their balance sheets. A recent speech by RBA senior official, Guy Debelle, suggests the RBA would agree with this view.

In other Western countries, timely indicators have also been on the weaker side, partly reflecting the effect of the Japan crisis and higher oil prices earlier in the year. Nonetheless, some part of the weakness is likely to be more fundamental, and our global team have revised down developed country growth forecasts from 2.1% to 1.8% for 2011 (see An Uphill Struggle, 29 June 2011). At the same time, however, the developed world inflation forecasts have been revised up slightly. As the team points out, high levels of debt in western countries mean that structural growth rates are now lower, so that inflationary pressures can build even with low growth rates. Monetary policy settings are also still very stimulatory, which is boosting commodity prices and thus inflation.

But from Australia’s perspective it is really Asia that matters. And while the Asian data have weakened a little in recent months, the story is quite different to that of the West. Weakness in Asia seems to more clearly reflect the temporary impact of the Japanese disaster and also the ongoing effect of tighter policy, particularly in China. Chinese officials still seem more concerned about inflation than growth, with the reserve requirement ratio lifted further during the month.

Of course, the key channel by which global events affect Australia is through commodity prices. And with coal and iron ore markets still very tight, commodity prices have skyrocketed in recent months. With commodity prices at these levels, the growth impulse from the world to Australia is still very positive.

Much ado about nothing, or something more sinister? A key issue for the timing of the next RBA move is whether the recent run of softer domestic indicators persists. Two key indicators are the employment data and the surveys of business conditions, both of which have softened a bit recently. The question is: is this temporary or a more fundamental slowdown?

On the labour market, at the same time as demand for labour has weakened, so too has supply of labour, due to significantly weaker migration. So the labour market has remained tight, with the unemployment rate at 4.9%. And it is this balance between the demand and supply of labour that matters for wages, inflation and thus rates. Wage indicators are already running at an uncomfortably high clip, with indicators from the GDP release showing very fast growth in unit labour costs, due to rising wages and very weak productivity growth.

Across the components of the employment data, the story is more mixed.

On the one hand, male unemployment has continued to trend down to be at very low levels (4.5%), suggesting significant tightness in the part of the labour market most likely driven by the mining investment boom (we think the mining investment boom is creating more male than female jobs).

On the other hand, the full time component of employment has fallen in the past couple of months, a worrying sign, with part-time employment rising to more than offset this weakness. Job vacancy indicators have also softened recently. If this is the beginning of a sustained trend, then perhaps the economy is a bit weaker than we expect. Perhaps the structural transition to an economy driven more by mining is taking longer than expected. While not our central case, this is a clear risk. We continue to expect solid employment growth in coming months.

Business conditions and confidence have also eased in recent months, though it is worth pointing out that they are still both above average levels and probably understate the situation in the mining industry as these firms are only a small part of the NAB survey’s sample. The other potentially worrying sign in the past month has been reports of cost overruns putting some mining projects at risk. But again, the key question here is how this will impact inflation. Our view is that the cost overruns are an upside risk for inflation as they show that the economy is hitting its capacity limits. Any cancellations or delays of projects will probably mean slower growth in investment volumes, but this is driven by supply side constraints not weaker demand, which we think will be inflationary.

Overall, our view is that the current softer patch is largely temporary reflecting some transition dynamics for an economy that is becoming more mining sector dependent, and that the underlying economy will continue to strengthen over the forecast horizon. But one cannot rule out the possibility that the slowdown is something more sinister, which is a risk to our central call of next hike in August and 100bps of hikes by mid-2012. However, the possibility that the next move is down is still, in our view, a very small risk.

Critically, the Q2 CPI numbers, printed on 27 July, will give us a clearer view on how the weaker demand indicators look relative to supply. We expect an elevated Q2 CPI and for the RBA to respond in August.

RBA officials take centre stage A number of speeches by RBA officials this month provided insights into thinking from 65 Martin Place.

Mid-month, the governor gave a speech on economic conditions and prospects. The punch line for markets was the repeat of phrasing from the hawkish early-May RBA official statement, suggesting hikes would be required ‘at some point’. The governor also reiterated and referred to the quarterly official statement’s set of inflation forecasts, somewhat allaying concerns that developments since then may have led to a significant change of view. Comments from the governor also implied that another set of prices data, due in late July, would probably be needed to get the board over the line.

We also heard from assistant governor Phil Lowe during the month on inflation. On its face, what is most striking from his most recent speech is just how hard it is to explain the inflation generation process, and therefore forecast inflation, even for the central bank.

The speech reiterates the sense we had from the early May quarterly official statement (RBA Observer Update, 6 May 2011) that the RBA is now more explicitly linking the domestic inflation story to global commodity prices. This is perhaps a reason why, as Lowe suggests, ‘what did surprise us [about the 2007/08 rise in inflation] was the amplitude and timing of this cycle in inflation’. Were commodities an omitted variable last time around? If so, then the current very high levels of commodity prices may tell us something about the risks to inflation. They are to the upside!

Lowe also talked about housing costs (including electricity) being a major upside contributor, and with the current undersupply of housing and power plants it is quite clear that these upside risks persist. Then he highlighted the significant recent pick up in unit labour costs and the medium term relationship between these and inflation, reminding us that productivity growth is extraordinarily weak and it will be quite a challenge to lift it. More upside risk to inflation!

It seems Lowe, at least, is very worried about inflation.

Curtain call Rates are on hold this month. We think the next hike will be August and are still calling for 100bp by mid-2012. However, recent weaker domestic and global data suggest the risk is that it will take longer before rates rise, and that the whole process may be more elongated. Nonetheless, we think the risk that the next move is down (as markets have been pricing recently) is very small.

Paul Bloxham, Chief Economist (Australia and New Zealand) HSBC Global Research Economics - Data Reactions 1 July 2011

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