The war in Ukraine has changed the outlook for economic growth and inflation. To date the escalation of hostilities in Ukraine and the escalation of economic sanctions...
We concluded that June is firming over August for a cash rate hike in the article “Growth and Inflation” last week. Data releases and developments in Australia and overseas over the past week have increased the likelihood that Australia’s rate tightening cycle will start in June. The stronger-than-expected February labour force report and Q4 house price report, more local pay disputes, confirmation that the 29th March Federal Budget will provide some compensation to households for rising cost-of-living pressure plus rate hikes overseas all place pressure on the RBA to hike sooner, although key information and events in April and May still make a rate hike unlikely before June.
Turning to the factors that have increased the pressure on the RBA to hike sooner, the February labour force report showed further tightening of labour market conditions adding to developing upward pressure on wages. Employment rose 77,400 in February, well above 40,000 market forecast and with full-time employment up 121,900. The labour force participation rate rose to a record 66.4% from 66.2%, lifting labour supply but at half the pace of rising employment. The unemployment rate fell from 4.2% to 4.0%, matching the lowest reading since the quarterly labour force survey started in 1978. The underemployment rate covering those working less hours than they would like, fell to a 15-year low of 6.6% in February.
Labour market movements typically lag change in economic growth by several months. The latest Q4 2021 GDP growth reading was exceptionally strong, up 3.2% q-o-q, 4.2% y-o-y. Strong growth is likely to persist through Q1 at least given potential household spending from accumulated savings during the pandemic restrictions and a boost to national income from high commodity prices given a new lease of life by the Ukraine war. In short, tight labour market conditions are likely to get much tighter over the next few months with the national unemployment rate straining down through 3% territory.
While the latest Q4 wage price index reading at 0.7% q-o-q, 2.3% y-o-y was just inside comfortable territory for the RBA’s 2-3% inflation target medium-to-longer term, the tight February labour market reading, and even tighter readings ahead point to much higher wage price readings before long.
One factor contributing to low past wage growth has been the low caps on public sector pay increases. Those low caps are under attack, in New South Wales in particular, where nurses, paramedics, public transport workers and teachers are all actively pursuing an annual pay rise above 2.5% - as much as 7.5% in the case of teachers. The risk is rising of a jolt higher in annual wage growth above 4% y-o-y before the end of 2022.
Another factor that will directly push inflation higher is rising house prices and rents. The official ABS reading of house prices for Q4 2021 managed to surprise on the high side of high market expectations, a quarterly rise of 4.7% q-o-q against market forecast of 3.9%. Annual growth in house prices nationally was 23.7% y-o-y, but even higher in Sydney, 26.7%; Brisbane, 27.8%; and Hobart, 29.8% y-o-y.
While there are signs early in 2022 that upward house price pressure is moderating, the past extreme lift in house prices has priced home purchase out of reach for a growing number adding to the ranks of those seeking to rent. At the same time, housing landlords are trying to reflect higher house prices in rents. The housing component of the CPI, up 1.8% q-o-q, 4.0% y-o-y in Q4 2021, is destined to show bigger increases in Q1 and Q2 2022.
The Federal Budget on 29th March has become another factor more likely to support than suppress inflation. The economy is in much better shape in 2021-22 than forecast by Treasury as recently as 3 months ago in the Mid-Year Economic and Fiscal Outlook. Treasury was forecasting annual GDP growth at 3.75% in 2021-22 and an unemployment rate in June 2022 of 4.5%. Growth seems to be running close to a percentage point stronger than Treasury forecast and unemployment probably a percentage point lower. Those changes alone make a large difference to the forecast Budget Deficit for 2021-22.
Another big deficit reducing factor relative to Treasury forecasts in December is that key export commodity prices have risen sharply rather than fallen during 2021-22 so far. In the May Budget last year Treasury forecast an underlying deficit of $A106.6 billion in 2021-22. In the Mid-Year review in December that was revised down to $A99.2 billion and the Budget in just over a week’s time will probably see a further downward revision to around $A70 billion. The Government will undoubtedly play up how budget repair will progress in 2022-23 and beyond, but that is irrelevant to the pressure that is building now early in 2022.
For inflation pressure building now it is government spending in this current financial year, 2021-22 that matters. What the Government does with the windfall improvement to its Budget deficit from higher-than-expected growth and commodity prices and lower-than-expected unemployment will influence the building inflation pressure in the economy. Using any of the windfall to fund additional spending, including compensation for cost-of-living increases, will add to demand in an economy already growing fast enough to stretch supply and push up prices.
Apart from the local factors pressuring the RBA to hike the cash rate, key central banks overseas are hiking rates and promising more hikes over the coming months. The US Federal Reserve increased its Funds rate last week by 25bps to 0.50% for the first time in the current cycle and indicated regular rate hikes taking the Funds rate above 2.50% next year. The Bank of England hiked 25bps for the third time in as many policy meetings taking the Base rate to 0.75% and is promising to keep lifting at each policy meeting.
The RBA’s 0.10% cash rate is rapidly becoming an anomalous low outlier in a world that is recognising that high inflation is unlikely to be a temporary phenomenon and needs containment. The RBA may still want to check the next releases of the CPI and wage price index in late April and mid-May before committing to a rate hike. Neither will provide comfort that inflation pressure is easing in our view. We now see the first rate hike from 0.10% to at least 0.25% occurring at the RBA’s June policy meeting with another three rate hikes to 1.00% by end-2022.