RBA remains patient on rate hikes

The RBA continued to keep rates on hold this month even though Inflation picked up more quickly than they expected. The length of time it took to resolve supply chain problems, which have been pushing up prices continues to be a source of uncertainty regarding the inflation outlook, as are developments in global energy markets. With Russia’s war with Ukraine continuing to play out, and the market slowly recovering from a pandemic, what’s the outlook for interest rates?

Tune in to hear Darren Langer and me discuss this in episode 25 of The Rate Debate.

Transcript

Darren - Hello, and welcome to the Rate Debate. I'm Darren Langer co-head of fixed income at Yara Capital and joining me as usual is my co-portfolio manager Chris Rands.

Well, it's Tuesday 1st March and the RBA has just met and it's pretty much as usual from the RBA. Chris, there wasn't anything new in their statement from what I could see?

Chris - No, the statement looks pretty much like last month with the RBA telling us that they expect to be patient and that the world's still uncertain.

Darren - Yes, they've used two words that I think are key to their mindset. They've used the word ‘uncertainty’, which this time was linked more to what's happening in Ukraine. And they use the word ‘patience’, which we've talked about a few times. They're really in a mindset that they don't want to move too early and risk any kind of recovery at all. 

They're just willing to run things a little bit harder for a bit longer than maybe many people in the market are comfortable with. 

But, you know, as we've said many, many times before, central banks tend to over tighten and to kill off the green shoots of growth. It seems like Governor Lowe is willing to wait and be as patient as possible. So, from our perspective, what do you think patience means at the moment?

Chris - I think when you look at what the RBA has been saying over the past 12 to 18 months is that they're going to be hiking when the inflation rate is sustainably in that 2 - 3% range. So, as we know inflation is back in that 2- 3% range for the first time in six years. if I was looking at this, I would be saying sustainable is probably expecting to remain in that band for 12 to 18 months. So, if they see another inflation print come in that 2- 3% range, maybe a little bit higher, and they are still forecasting that that's going to persist into 2023, then I think that would be when you start to get ready to pull the trigger. The problem that I see from the markets thinking is that we spent a long time getting back into the 2-3% range, and if we think back to last year, there was a lot of talk that maybe we should let inflation run higher for a little bit of time. I think it would be silly to kind of step in at the first sign that inflation is here. 

I think they want to see at least a couple of prints and that sets them up, potentially, for the back half of this year to be doing something, if not, maybe even the start of 2023.

Darren - Yes, there's been a lot of talk to around wages. The RBA brings their forward guidance back to the fact that they want to see wages pick up before they tighten rates. We did get a recent wages number, but from the way I look at it, it looked much the same as it has for the last few years. Yes, there was a slight tick up if you squint hard and look at it. But some commentators were talking about there being broad wage gains across the economy, but it was hard to see in the aggregate number. What are you seeing?

Chris - I went through and looked at the different sectors and what was moving just to get a feel for whether it is broad, or whether it's isolated to certain sectors and, if squint hard enough, maybe you can say that it's broad and picking up, but it does look the same as what we've seen over the past four years. If you break down the different sectors, there was only one that was above 3% and that was accommodation and food services, at about 3.5%. And then the next highest sector was retail which traded about 2.6% year-on-year. So, what we've heard is that restaurants are struggling to find workers in the retail sector and, even with that pressure, even with a 4% unemployment rate, you're not really seeing wages pick up substantially. 

There are still three sectors that are below 2%, which I found interesting which were mining, transport, and postal services. 

It's interesting that even in that area we're not seeing wages pick up. It is slightly higher than it's been over the past four years, but in terms of the industry breakdown, there's nothing even really flying higher now. So, I think from the RBA’s perspective, they're going to look at that and say, well, wages are picking up slightly, but it's nothing to kind of write home about yet.

Darren - Yes, and I think one of the things we’ve talked about before is the level of public sector wages which I think are still quite low, below 1%. It's very hard to get private sector wages running hard if the public sector is constantly dragging the level down. And we have governments on the one hand saying private enterprise needs to pay people more. But, on the other hand, you've got them keeping a really tight reign over their own wages’ bills, which is understandable because government expenses are heavily linked to CPI, and they can't afford CPI to go racing off too high that it lifts all government charges and everything along with it. But it's a catch 22 where they want private sector wages to grow, but at the same time, they don't want public sector wages to grow, so it's not really going to work long term.

Chris - Yes, and on top of that, when you look at those two sectors that I mentioned that were seeing the wage gains—the accommodation and food services and retail trade—those aren't really sectors that would probably drag the entire wages bucket higher with it. Historically, you would expect to see that the higher value wage area is pushing it, and on top of that, as the borders start to reopen, if we start to get more and more people filling those accommodation and food services and retail trade jobs, then perhaps those wages can be capped as the student workforce returns and fills those jobs.

Darren - Yes, the other thing with that is that it’s probably in industries where there's a tipping point to where people just won't pay above a certain amount for those services either. You know, the choice to go out to a restaurant versus a choice to stay at home and cook. You just can't keep jacking the prices up to pay people more and more. 

The thing that also sits in the back of my mind is industries that are probably ready for automation at some point in time. 

It could well speed up some of those kinds of factors as well, obviously not in this short run, but longer term. If you start to get wage pressures, they can be automated out of the system rather than necessarily constantly getting pay rises. So yes, it's one of those things that will be interesting to see. I think the way automation and other things are going, labour is going to constantly struggle to get higher and higher wages because of technology. I don't think that trend has changed just because we've had a pandemic and a few shortages and a few supply chain issues.

Chris - I guess the one last positive is, if wages rise to 3% and core inflation sits at 2.5%, that's exactly what the RBA has been aiming for. So, you look at this economic information, and the market economists have been a little bit upset with it, but, at its rawest, it's what you would expect the economy to be putting out when it's in that steady state. So, it's not the end of the world. Certainly if it stays here, it'll just slow the RBA down in being able to tighten rates.

Darren - So, I guess that brings us on to the fact that a few market economists were starting to get a bit excited about possible RBA hike in June. 

 I think the number that came out for wages was probably low enough to put the RBA on the sidelines for a bit longer. We've got another inflation print in April. We've got the election coming up over the next couple of months. There's probably not a lot of upside for the RBA to tighten just yet. It probably pushes it back to more like August at the earliest. 

That's certainly not our call, but I would think August at the earliest and probably the latter half of 2022—they love November. But I think it's hard to see based on the numbers so far, that the RBA’s got a lot of justification.

Chris - And this feeds into something that we've looked at recently with the timing of when the RBA goes and what they like to see. Unlike offshore, I've never understood why we receive our inflation prints quarterly. We have the monetary policy that's set off that figure, yet we see the number four times a year because of that. The next inflation figure comes in April and then after that, it turns up in July. The problem for the RBA is if they see a high inflation print in April, then there's a federal election coming in May, they'll probably want to sit on their hands then and then by the time we roll through that, it's basically June. And they'll probably be thinking, I wouldn't mind seeing one more, which would put them at July, and that sets it up for what the RBA has said recently, which was they probably want to see a couple more inflation prints. You can figure out what a couple more means, but that felt like they want to see at least two. And again, as you say, if they want to see two, then they're not going to see the next one until July. And that opens them up for the second half of this year, but I think it's going be rare or hard for them to want to go in May. And historically, June and July has not really been a timing that they go either.

Darren - And I think April, when the next CPI comes out, if we had a shocker of a number, that might change the timing a little bit, but it would have to be awful to shake the RBA out of their current policy settings. And we haven't really seen much to sort of say, we're going to get that US style shock to CPI. There are things bubbling along in the background, but there's other things still offsetting them. The RBA talked a little bit about fuel prices. The cost of fuel is obviously a lot higher than what it's been in recent months. We've already seen a sharp adjustment to petrol prices. Ukraine may see that continue, but I think the RBA knows deep down that there's not much they can do about it. Interest rates are not the tool to control global oil prices. I think they're trying to talk their way away from fuel led inflation as being a trigger for rate hikes rather than let that simmer in the background. So, I think it was interesting for them to actually be very specific on that this time.

Chris - I think that makes sense and certainly, when you look at what they're communicating, and where the market is pricing, if oil does continue to pick up, then headline CPI probably will continue to push higher, so that potentially can take the headline figure into the 4% range which would be the highest number in a very long time for the RBA. But what you probably want to look at is the core CPI number in that instance, because the core CPI figure is going to be telling you more about the domestic economy than what's going on offshore, that's causing the oil price to jack higher.

Darren - It's an interesting point. We've actually seen some of the federal reserve governors talk about whether core inflation versus CPI inflation is actually the right number. And some of the more dovish members in the past, on the federal reserve anyway, are talking more about CPI as opposed to core CPI. Would it make a lot of difference?

Chris - I've been mixed on this. I remember seeing, I think it was one of the Fed Presidents about six years ago, say we probably should be focusing on headline CPI, because that is what matters to people. You can cut things out, you can massage it and say core CPI is not running as hot, but at the end of the day, headline CPI is what people are going to be paying for their goods. That's the thing that we want to control. Certainly, that makes sense to do it that way, but given that the RBA is trying to figure out how low it can drive the unemployment rate, you're getting caught up in a demand source that moves away from the economy. 

I personally think the RBA is probably going to focus on core CPI, because it's going to tell them more about the recovery of the Australian economy. But unfortunately for anybody that's spending their money, it's going to be the headline CPI that matters the most to them.

Darren - I think the main risk to that is it probably adds a lot more volatility. We probably would've cut interest rates a lot faster, and a lot more than what we did in the last five years. And then you probably start to get tightening a lot more often. I'm not sure it would make a huge difference to the overall outcome. But it is obviously something that these guys are thinking about, and it would change some of the perception I get of what the level of inflation in the economy is that matters. But I guess it's more of a philosophical argument rather than anything that's going to get solved today. What else do you think could change the RBAs mind at the moment? Is there anything else simmering out there that might change the way they're seeing things?

Chris - I think that in terms of what most central banks are facing, talking about hiking, talking about unwinding QE, that's going to be what the RBA follows, because historically the RBA isn't a leader, they're following what the other central banks are doing. So certainly, we are in this environment where we'll probably be taking our lead from the Fed. We see what they do in March. So that will be a pretty good signal of what we can expect going forward. 

The key thing that I think could put a bit volatility into the market is just what happens if credit spreads widen, and if equities start to look a little bit shaky because of the conflict that's going on in Europe.

Historically this has paused their rate hikes when equity markets start to fall. So, if there is a sign here that equity markets don't quite like what's going on, then I'd probably still expect the Fed to be hiking. But we might see the pace of hiking reduced considerably and that will just mean that the RBA’s not quite as far behind as everyone else and maybe everybody will be able to coalesce around their view that they are able to be patient here. I think the reason the market wants to force them so much is everybody else is talking so much hiking and it feels like we're going to be left behind. I'm not sure that we're going to be left behind, but certainly I think that's what the market is thinking.

Darren - I guess the other curve ball is that we've talked about this before, that markets tend to either think all things are getting better, or all things getting worse. But we've seen constantly over the last five to 10, probably 20 years, that there's always something that crops up that no one expects. 

This conflict between Russia and the Ukraine, and to some extent, the reaction by other countries to it, has probably been a lot bigger than what many people might have thought. 

We're certainly not experts on global politics and we wouldn't want to make too many comments on what the likely outcome and the direction of this is, but it's going to be in the back of the RBA’s mind and probably the Feds as well that it's not an environment now where we can categorically say we're going to grow our way out of the COVID problem. It's just probably adding more to the confusion of what's the right way to tighten policy and to try and get inflation under control, particularly when at the moment, energy prices are probably the main thing driving global inflation, and that's something rates really doesn't do a lot for.

Chris - Yes, and if you look at the timing, and certainly what the RBA seems to be saying with the word ‘uncertain’ is: what's the RBA going to do, and when are they going to do it? It feels like the real answer here is if they need to see the inflation print come July, and we're not certain if they're going to hike until August or November. You're in this period of who knows what could occur. A few things that stand out here is we've been stopping and starting because of COVID. 

Now there's a war, the Federal Reserve will begin unwinding QE this month, and on top of that, it's starting to look like house prices are starting to peak in Australia as well. So, to say that they're definitely going to do something in six months’ time seems like a bit of a stretch. 

And I think that's what the RBA is telling us. Things are uncertain at the moment. Let's just give it a little bit of time. If inflation and wages pick up, we're going to be ready to go. And if they don't pick up, then we'll be monitoring the situation. But it's just the timeframe that we're looking at here because things change so quickly.

Darren - Yes, it was refreshing to see the RBA almost say we don't know either but we're waiting to watch and see what happens. It's a rare set of honesty in financial markets when someone admits they don’t know what's going on.

Chris - And the other side of that is if you look at a central bank like the Fed, then their inflation rate is sitting closer to 6/7%. So, they are in a position where they are ready to go. If that's where the RBA was looking at for inflation here, I think they would be ready to go too, but it's not, so we can sit back and give it a bit of time first.

Darren - We'll finish up there with the word ‘uncertainty’ because that's pretty much how I feel. It's a really difficult time and there is a lot happening to make any hard and fast calls. But certainly, we still think a flatter and longer trajectory for monetary policy is more likely outcome, which is very much against what markets think at the moment. But that's still our main call and we haven't had a lot of evidence to tilt us away from that. But all the things that we've mentioned today could change that very, very quickly.

Tune in next time

So, that's it for the month. If you ever want to suggest topics or discuss further anything with Chris or I, we can be contacted at theratedebate@yarracm.com. Tune in next month when we deliver our latest thoughts on the RBAs April rate decision and provide an update on what's been happening in markets. Until then, stay safe.