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Economic and Financial Market Update: Is Australia different

19 September 2022

Summary:

Cash rates in Australia have got further to rise;
Financial markets believe the peak in the cash rate will be lower in Australia than peer countries;
There are good reasons for that: wages growth and inflation expectations are lower and household debt higher;
But Australia is also enjoying a bigger boost from the terms of trade than most countries.

In September the RBA decided to raise the cash rate by a further half percentage point (taking it to 2.35%). It was only in April that the cash rate was 0.1% so the move up has been rapid-fire. The reasons for the aggressive shift in policy are well known: the economy is performing well, inflation is too high, and interest rates were too low.

The minimum requirement was that interest rates needed to move up to a more ‘normal’ level. But the concept of what is a ‘normal’ level of interest rates is a mythical economic beast, one best spotted in the rear-view mirror of historical economic data. The movement of equity and house prices and pace of credit growth made it pretty clear that a ‘normal’ level of interest rates is comfortably above zero. Conceptually you would also think that a ‘normal’ level of interest rates should be above the expected inflation rate (a point made often by RBA Governor Lowe). How much higher though is the unknown.

Worries about what is the ‘normal’ level of interest rates in some respects is of academic concern. The right level of interest rates is the one that helps get inflation back to target (2-3%). To complicate matters, how high interest rates will need to rise will depend upon a range of factors including how business and consumer confidence evolves, what happens with fiscal policy as well as movements in supply chains (notably for commodity prices).

It will also depend upon what is happening to interest rates in other major economies. The RBA (and all central banks) make the point that monetary policy is set upon what is happening in the domestic economy. But in a globalised world major events have global consequences (such as what is currently happening with commodity prices). That is one reason why Australian interest rates often move with global interest rates (proxied by what happens in the US). Another is that country differences of interest rates can influence exchange rates.

As at 16 September the expectation for the peak of the cash rate in peer countries (US, UK, Canada and New Zealand) is somewhere in the range of 4-4.5% (the expected peak in European and Japanese cash rates is lower reflecting their history of slower economic growth and lower inflation). This suggests that our peak in the cash rate should be at least in a neighbourhood ballpark (at the time of writing it was 3.75-4%). We are also in a world where central banks are moving fast. Rate hikes of (at least) three quarter percentage point are expected at the next US, UK and European central bank meetings (again as at the time of writing).

There is a decent argument that the high level of household debt means the peak in the cash rate in Australia should be lower than other countries. (notably the US) in this economic cycle. It is less clear though why the Australian cash rate should be much below other countries such as Canada and New Zealand as they also have high household debt but are not benefitting to the same degree as Australia from the current level of commodity prices.

The run of domestic economic data will start to matter more with the problems in global supply chains starting to ease and commodity prices looking to have peaked (with the important exception of gas). The RBA believes that the greater stability of inflation expectations in Australia and the slower domestic pace of wages growth provides them with room to move the cash rate at a more considered pace.

It is true that Australia currently has lower wages growth than the US (as well as other countries such as the UK, New Zealand and Canada). Given how low the unemployment rate is it is a bit of a mystery as to why wages growth in Australia is not stronger. Government restrictions on public servant pay rises has played a role (this is changing). Wages growth in Australia does appear to be less volatile than in peer countries. This has been put down to how wages growth are determined in Australia (through a mixture of awards, enterprise bargaining and individual contracts) that means it takes longer for changes in labour market conditions to impact wages growth.

Critically whether wages growth and inflation remains low will depend upon what firms and households expect inflation to be in the future (in the jargon, their ‘inflation expectations’). If they anticipate that inflation will remain high then that is how firms will set prices and what wages growth workers’ will demand. For households that think that inflation will remain between 0 to 5% they believe that price growth has returned back to where it was pre-GFC. If that is true inflation might end up being a bit high but not a significant problem. But if you ask all households their inflation expectations has risen back towards their highest level in almost thirty years. In this regard Australian responses are consistent with what households are saying in other OECD countries.

One problem in Australia is that there are no good measures of consumers’ views about inflation in the long term (ie, further out than one year). This is important because it provides an indication whether households think the current movement in prices is a one-off move or something that will be more permanent. In the US households apparently have not marked up significantly where they think inflation will be in a few years’ time. By contrast they look like they have done that in the UK.

At the end of the day what matters is not what people say but what they do. Household and business inflation expectations are essentially driven by how much prices grow. If those prices rise high enough for long enough then their view as to where inflation is heading will rise.

Research suggests that it is financial market views on where prices are heading tend to provide the best indicator about future inflation. The good news is that at present financial markets expect inflation to decline back towards the RBA inflation target over the next couple of years and remain there over the medium term.