Reserve Bank of Australia (RBA) Governor Philip Lowe delivered his first speech of 2018 last night.
While there was the usual optimism conveyed about the outlook for the economy, business investment and Australia labour market, it was the Governor’s commentary on the inflation outlook, in particular wage growth, along with Australia’s housing market, that created the real talking point.
With markets starting to price in the likelihood that the RBA will begin to lift rates as soon as May this year, Lowe delivered some key phrases that hint the bank is far from ready to follow the lead of the US Fed, Bank of Canada and Bank of England and begin to lift interest rates.
We’ve highlighted a few of the key paragraphs below, including the admission that without a lift in Australian wage pressures, the bank not be able to achieve its inflation goals.
The inflation outlook
(Our emphasis in bold)
On the prices front, we continue to experience subdued outcomes, although inflation is higher than it was a year ago. Over 2017, inflation was a bit under 2%, in both headline and underlying terms. Last week’s data provided further confirmation of trends we have been witnessing for some time. Increased competition in retailing is contributing to price declines for many consumer durables. And subdued wage increases are contributing to low rates of inflation for a range of market services. The rate of rent inflation also remains low.
The immediate outlook is for a continuation of these broad trends, but for inflation to pick up gradually as the economy and labour market strengthen. We are expecting CPI inflation to be in the 2 to 2.5% over the next couple of years. Underlying inflation, which is less affected by the scheduled increases in tobacco excise, is expected to be a bit lower than CPI inflation.
So while the RBA expects inflationary pressures to gradually lift, it still sees headline CPI remaining at the lower-end of its 2-3% inflation target. Core CPI — of more importance when it comes to interest rate settings is even expected to be lower.
And the governor delivered an important caveat on the importance of wage growth that we focus on below.
The importance of wage growth
In the current environment, some pick-up in wage growth would be a welcome development. Ideally, this would be on the back of stronger productivity growth. But even if productivity growth were to be around the average of recent years, a faster rate of wage increase should be possible. Indeed, a lift in wage growth is likely to be necessary for inflation to average around the midpoint of the 2–3% medium-term inflation target. Stronger growth in real wages would also boost household incomes and create a stronger sense of shared prosperity.
Our central scenario is for this pick-up in wage growth to occur as the economy strengthens, but to do so only gradually. Through our liaison with business we hear some reports of wage pressures emerging in pockets where labour markets are tight. We expect that over time we will hear more such reports. After all, the laws of supply and demand still work.
So the RBA expects wage growth to lift, albeit gradually, as labour market conditions tighten leading to some pockets of skill shortages.
However, the phase that wage increases would be “welcome” does not fill one with confidence that it will actually happen.
Indeed, the caveat that a “lift in wage growth is likely to be necessary for inflation to average around the midpoint of the 2–3% medium-term inflation target” is important. Wage growth undershot by some margin in Q3 even with a hefty increase in the minimum wage rate and strong employment growth.
That makes the upcoming Q4 Wage Price Index — released on February 21 — a key release when it comes to the outlook for interest rates.
The Governor also touched upon a strong lift in labour market participation, something that may hinder wage growth despite strong levels of employment growth.
Labour market conditions
Particularly noteworthy has been the labour market, with employment increasing by 3.25% over the past year. This strong performance has been accompanied by a large number of people joining the workforce, so that the participation rate has returned to around the level reached at the peak of the mining investment boom. There have been noticeable increases in the participation rates of both women and older Australians. At the same time, the unemployment rate has declined to around 5.5% and a further gradual decline is expected over the next couple of years.
This is important.
While the unemployment rate is falling, a strong lift in the number of Australians joining the workforce making this process slower than what would have been the case if participation levels were steady.
Yes, labour demand is rising faster than supply right now, but eroding labour market slack remains slow, hindering a key ingredient required to help build wage pressures.
The final part of the speech that really caught the eye was Lowe’s commentary on the housing market, specifically that the bank sees current conditions as “less risky than it was a while ago”.
We have worked closely with APRA, including through the Council of Financial Regulators, to address these issues. This work, together with other steps taken by APRA, has helped improve the quality of lending in Australia. In the housing market, there has also been a change. National measures of housing prices are up by only around 3% over the past year, a marked change from the situation a couple of years ago. This change is most pronounced in Sydney, where prices are no longer rising and conditions have also cooled in Melbourne. These changes in the housing market have reduced the incentive to borrow at low interest rates to invest in an asset whose price is increasing quickly.
On balance then, from a macro stability perspective, the situation looks less risky than it was a while ago. We do, however, continue to watch household balance sheets carefully as there are still risks here.
That suggest its concern over the housing market is now far less than it once was. The bank appears content that current macroprudential steps taken by APRA are working to cool the housing market conditions, hence mitigating the need to use interest rates to cool activity levels.
In his concluding remarks, Lowe also offered some age advice for those speculating that rate increases from other central banks meant the RBA will soon follow suit.
“We did not lower our interest rates to the extraordinarily low levels seen elsewhere after the financial crisis,” he said, adding that “we didn’t have a meltdown in the financial system and we experienced a very large cycle in commodity prices and mining investment.
“Just as we did not move in lock-step on the way down, we don’t need to do so in the other direction.
“Our circumstances are a little different. We are still some way from what could be considered full employment and our central scenario for inflation is for it to remain below the midpoint of the medium-term target range for the next couple of years.”
Lowe said that he expects “further progress in reducing unemployment and having inflation return to the midpoint of the target range”, noting that “given recent developments in Australia and overseas, it is likely that the next move in interest rates in Australia will be up, not down”.
But that, given current circumstances, will take some time, he said.
“While we do expect steady progress, that progress is likely to be only gradual,” he said.
“Given this, the Reserve Bank Board does not see a strong case for a near-term adjustment in monetary policy.”