Inflation Watch

At the latest combined meeting of the IMF and World Bank the heads of the world’s major central banks seemed close to agreeing that the global economic recovery is entrenched and that inflation is unlikely to stay low for much longer. It was the clearest warning so far that the world’s central banks will be reducing monetary accommodation and in some cases lifting interest rates.

US Fed Chairman, Janet Yellen reaffirmed the Fed’s view that notwithstanding still quite low underlying annual inflation below 2% it will pick up. The Fed has indicated previously that it will hike its funds rate another 25bps (the fifth hike in the current cycle) to 1.50% before the end of this year (most likely at its mid-Dececember policy meeting) and plans another three hikes in 2018. The Fed is also starting a slow sell down of bonds from its $4.5 trillion holdings.

European Central Bank Governor Mario Draghi confirmed that European inflation is likely to rise from 1.5% y-o-y currently and that another reduction in the size of the ECB’s monthly purchases of bonds is imminent and will probably be announced at its next policy meeting later this month. It is increasingly difficult to see how the ECB can maintain its official deposit rate at -0.40% especially with global and European growth probably accelerating further over coming months. Market expectations about European interest rates would seem to be at risk of a major upward adjustment at some point in 2018.

The Governor of the Bank of England, Mark Carney also provided strong hints that Britain’s comparatively high inflation rate and lack of spare capacity meant that an interest rate hike would be delivered over the next few months. The Bank of Canada is likely to deliver a third interest rate hike before long as well.

Over the next few months there is a high risk, in our view, that the market’s view about interest rates and bond yields will lift sharply higher based on a mostly upbeat economic data around the world; signs that inflation is starting to lift; and monetary policy tightening moves by several key central banks. It is hard to see why this upward pressure on interest rates will not find its way to Australia as well.

The RBA has indicated that because central banks overseas are lifting interest rates it does not mean that it will lift interest as well. The RBA can point to special factors that may allow it to keep its cash rate low even as other central work towards slowly normalising their official interest rates. One special factor is high household debt in Australia implying that soft household retail spending could weaken on any additional pressure on household budgets such as an increase in borrowing interest rates.

The high household debt special factor, however, is problematic in the sense that unusually low interest rates contributed to households taking on too high a debt load in the first place. Leaving interest rates low as the economy improves may prompt households to borrow even more and leave the sector and the entire economy vulnerable if the value of assets backing high household borrowing – mostly housing – fall in price. The high household debt special factor cuts two ways. Leave interest rates low to allow households to spend more now but at the risk of a bigger pull-back in spending down the track. Raise interest rates to encourage households to cut back debt but at the cost of lower household spending in the near term.

A second special factor allowing the RBA to leave interest rates low is low Australian inflation tracking below the RBA’s 2-3% target band. Some factors indicate that Australian annual inflation could stay low – very low wages growth and the firm Australian dollar exchange rate, but other factors are already pointing to some upward pressure on Australian inflation developing soon – local upward price pressure points on gas, electricity and housing costs as well as a lift in factory gate prices in almost all of the overseas economies exporting manufactured goods to Australia and especially from Australia’s biggest supply source China.

Even the factors helping to subdue Australian inflation may not stay down much longer. Australia’s labour market has tightened considerably after a run of very strong monthly employment growth numbers. Pockets of upward wage pressure are starting to show in areas such as construction and health care. The 3.3% minimum wage adjustment from mid-year is flowing through too. Annual wages growth is unlikely to stay below 2% y-o-y much longer. Higher wages growth is a mixed blessing. It will help households spend more freely but it will also ensure that annual inflation does not stay as low as it has been.

If the RBA tries to hold down the cash rate as other central banks start lifting their policy rates another consequence is likely to be that the Australian dollar exchange rate adjusts downwards. That could add upward pressure on Australia’s inflation rate as well.

The bottom line is that as global growth continues to accelerate and global inflation starts to lift and central banks overseas respond with tighter monetary policy settings it is unlikely that the RBA will be able to go its own way and hold its cash rate down. In our view, the risk is rising that market views about the interest rate outlook overseas and in Australia will adjust upwards and possibly quite substantially over the next few months.