THE KANGAROO CURVE: Deutsche Bank analysis suggests a big interest rate challenge ahead for the RBA

  • Deutsche Bank economist Phil Odonaghoe has created a twist on the Phillips Curve – the “Kangaroo Curve”.
  • It plots the historical relationship between core inflation and the Australian unemployment rate, and happens to be shaped like a Kangaroo.
  • Australia’s unemployment rate has recently fallen to 5%, and Odonaghoe says if it stays there the RBA may face a challenge to contain inflation in the years ahead.

Here’s an interesting chart that looks like a Kangaroo:

Deutsche Bank

Can you see it? (Head and front legs are in the red circle on the right). OK, bear with us.

From Deutsche Bank economist Phil Odonaghoe, it’s a slight twist on the standard Phillips Curve (which plots an inverse relationship between the unemployment rate and wage growth).

Odonaghoe’s Kangaroo Curve plots “underlying inflation against the unemployment rate that prevailed five quarters earlier”, going back to 1982.

So the latest data point on the chart — core inflation for the September quarter — is plotted against the unemployment rate for the June quarter in 2017.

And according to Odonaghoe, “what is potentially troubling is the Kangaroo’s hind legs”.

That’s because Australia’s unemployment rate unexpectedly fell to just 5% in September, then stayed there in October — an indication the previous result wasn’t an anomaly.

The Kangaroo’s hind legs (circled area along the x-axis) shows rates of inflation five quarters after the unemployment rate last fell below 5%.

Here’s Odonaghoe on why that could present a challenge to policy makers:

During this period:

  • The lowest underlying inflation rate seen five quarters after unemployment fell below 5% was 3% (Q3-2007), while the highest was 5% (Q3-2008).
  • The average underlying inflation rate, five quarters after the unemployment rate fell below 5%, was 4%. In other words, a full percentage point above the top of the RBA’s target band.
  • Currently, the RBA forecasts the unemployment rate will continue falling to around 4.75% by 2020.

    If that’s the case and low unemployment becomes more entrenched, Odonaghoe’s model suggest the RBA could soon have a battle on its hands to contain inflation.

    The data raises the question of what Australia non-accelerating inflation rate of unemployment (NAIRU for short) actually is.

    Currently, policy makers estimate Australia’s NAIRU is 5% — exactly where it sits now.

    But earlier this year, RBA deputy governor Guy Debelle noted the recent experiences of other developed markets which have lower rates of unemployment than Australia.

    So far, those historically low u/e rates have failed to translate into a sustained pickup in wage growth, as the standard Phillips Curve would suggest.

    In addition, Odonaghoe notes that his risk-sample is limited to the last eleven quarters between 2001 and 2008, which also coincided with the onset of Australia’s mining boom.

    “That said, we suspect that the RBA would greet a prolonged period of unemployment below 5% with some concern, given this ‘pre-GFC’ inflationary episode,” he said.

    “It is early days, of course, and the RBA’s own forecasts don’t see the “hind-leg” period emerging until the middle of 2020.”

    “Nonetheless, upcoming labour force surveys warrant close attention.”