Changing interest rate outlook

We are changing our view of Australia’s interest rate outlook essentially pushing out by six months the first RBA cash rate hike to August 2018 from February previously. The main reason why we are changing our rate forecasts is that it looks as if it may take longer for local inflation pressure to build. The trajectory of our forecast rate hikes beyond the first one is unchanged other than delay of six months. After the first 25bps rate hike to 1.75% in August 2018 we forecast a second 25bps hike to 2.00% in November 2018 before a pause through to May 2019 when we forecast a third cash rate hike to 2.25%.

The RBA’s quarterly Monetary Policy Statement released last Friday provided a catalyst for our change of view. The Statement maintained an upbeat economic growth outlook and recognised the strong improvement in employment through 2017 so far, but it also reduced forecast annual inflation by a quarter of a percentage point essentially to 2.25% for its more distant forecasts from late 2018 through 2019. The RBA gave several reasons for the slow build up in inflation including still some excess capacity in the labour market; the likelihood that weak wage pressure would be slow to subside; more subdued increases in house prices and rents; and stronger competitive forces building in the retail sector.

There are some inflationary pressures, but they are relatively isolated and in some instances one off in nature. We accept the RBA’s view of why inflation may be slow to build although we feel it is debatable whether inflation will stay subdued as long as the RBA is forecasting. Taken as they stand, the RBA’s latest inflation forecasts are consistent with the RBA leaving its cash rate unchanged throughout 2018. One problem, however, is that if the RBA leaves its cash rate unchanged at a time when economic growth is building momentum around the world and other central banks are slowly raising their official interest rate a feed-back loop could occur driving down the Australian dollar and driving up Australian prices.

The value of the Australian dollar is likely to matter rather more in determining Australian inflation over the next year or so. Part of the reason why it will matter more is that producer prices or factory gate prices overseas are rising more strongly because of lifting demand in the recovering global economy. Annual growth in producer prices is above 2% in the United States, nudging 3% in Europe and almost 7% in China. In these countries and regions producer prices were flat or falling between one and two years. More importantly they look set to rise at a faster pace over the next year.

Australian dollar strength has helped to ameliorate the impact of rising overseas prices on Australian inflation, but the Australian dollar is starting to show signs of weakening. The change in the fortune of the Australian dollar exchange rate is hardly surprising. Australia’s terms of trade (export prices relative to import prices) is coming under downward pressure. China’s attempts to rein in steel output to deliver a less polluted future bode poorly for Australian iron ore and coal prices.

It is not just potential weakness in the terms of trade starting to weigh on the Australian dollar the interest rate differential in favour of the Australian dollar is weakening too. The US Federal Reserve has raised its funds rate four times over the past two years and it now stands at 1.25% just 25bps below the RBA’s 1.50% cash rate. That differential will probably disappear in mid-December when the Fed is expected to hike another 25bps. If the Fed delivers a further three rate hikes in 2018 and the RBA does nothing US short term interest rates would be 75bps above Australian rates by the end of 2018.

At some point a likely weakening in the Australian dollar with its increasingly powerful feedback loop to Australian inflation is likely to figure more prominently in the RBA’s forecasts of inflation and its thinking about the cash rate. We accept that the RBA may be able to delay longer than we previously forecast before hiking rates, but the exchange rate pressure valve is unlikely to permit that delay to be much longer than a few months.

Apart from downward pressure on the exchange rate another key factor is just when upward pressure starts to build on wages. The RBA’s assumption is that wages growth will be slow to lift although lift it inevitably will as stronger employment growth especially in services starts to promote more pockets of labour shortage. There is a risk that wages growth accelerates faster than the RBA is forecasting and if this occurs the RBA would start to raise its inflation forecasts. In this scenario, RBA rate hikes might start around mid-2018.

Our best estimate is that the RBA will not have enough information to change its views about the inflation outlook before February next year although that information is likely to accumulate between February and August, especially as the Australian dollar comes under more consistent downward pressure.