Australia appears to be further behind in the inflation and interest rate cycle than many other countries. The RBA is also opting for a slightly different strategy to maintain the unemployment figures achieved since the pandemic. In doing so, they take advantage of the fact that the tax system suppresses household demand. It also avoids the risk associated with more aggressive tightening, which is that changing policy too late could lead to an unnecessarily sharp recession or a failure to hit the inflation target.
Labor markets in Australia and the United States have clearly changed. As Westpac colleague economist Ryan Wells reported yesterday, the unemployment rate rose to 3.7% in October and total hours worked appears to be flat. In the United States, the unemployment rate has increased by 0.5 points since the beginning of the year. Some of this reflects a slow recovery in the U.S. labor supply, but job growth has also slowed.
These developments have led market participants to focus on the question of when the central bank will change course and start lowering policy interest rates. But for Australia, the question remains whether the RBA needs to raise rates further. We are often asked why Australia has been slower to enter the rate cutting cycle than other developed countries. In this context, she is often asked why, even if the RBA raises interest rates further, the peak level is likely to be significantly lower than in the US, New Zealand and some other countries. Masu.
Part of the reason for the late peak is simply that Australia has been slower to spike and reverse inflation than many other developed countries. Thanks to the strict lockdown during the 2021 Delta Wave, we were able to reopen after the pandemic. So we then see a mismatch between demand recovery and the supply side that needs to be reconfigured for recovery. Given the extraordinary circumstances, it was inconceivable that Australia would follow the same path as countries like the United States. Not all economies have gone down that path. Much depended on whether policy support during the pandemic was sufficient to fill the revenue hole created by lockdowns and other health-related activity restrictions. This could not be assessed in advance. Japan and many other Asian economies are clear counterexamples to the US case, and domestic inflation has not taken hold in the same way. (See Westpac colleague economist Ileana Jain’s November 8 note.) So it makes sense to tighten policy in anticipation of a surge in inflation that has not yet occurred and is not certain to occur. It probably wasn’t the point.
Framed in this way, Australia can be seen as being about six months behind other countries in eliminating inflation. Like the US earlier this year, Australia is still at the stage where it was initially surprised by the slowness of the decline in services inflation. A further problem here is that the energy price shock from Russia’s invasion of Ukraine last year only trickled down to domestic retail electricity prices in July of this year. In this sense, the inflation cycle may also slow down somewhat.
Another key factor in the subsequent expected tipping point in interest rates is that the RBA appears to have chosen a ‘less expensive in the long run’ strategy for a variety of reasons. Foremost among these reasons is the RBA’s stated desire to maintain the recent rise in unemployment for as long as possible. The former governor made this clear, and Governor Bullock continues to use similar language.
Australia’s unemployment rate was 3.7% in October, about 1.5 percentage points below pre-pandemic levels. The RBA does not want these benefits to be reversed. Central banks in other countries probably don’t feel the same sense of urgency about this, even if they mandate full employment. The United States, the eurozone and Canada all achieved multi-decade lows in unemployment in the years leading up to the pandemic. So they may not be too worried about not being able to do so again.
Of course, the RBA’s strategy comes with risks, as the longer it takes to return to its inflation target, the more likely inflation expectations will rise, making it harder to bring inflation down. That bet seems to be paying off so far. Measures of medium-term inflation expectations are broadly in line with the target. Additionally, wage growth has not been as fast as in the United States, Canada, and some other countries. The wage-price index for the September quarter was very high due to the increase in incentives. But as Westpac colleague senior economist Justin Smilk reported on Wednesday, results outside the awards system suggest growth has peaked.
This relatively modest response of wages to a tight labor market contrasts with the experience of other countries. This ties in with some of the other reasons why the RBA was able to adopt this longer-term strategy.
The first, and most well-known, is that unlike the US and Canada, most home loans in Australia have variable interest rates. Therefore, monetary tightening is reflected in lending rates more quickly here and affects more household incomes earlier. Even if the endpoint of inflation is the same in other regions, the costs will be different. It is therefore understandable that the RBA may try to balance the trade-offs in a different way while still achieving its goals.
A little-known difference is that fiscal policy here works in the same direction as monetary policy to a much greater extent than elsewhere, especially as it relates to the household sector. As has been noted in the media recently, Australia is one of the countries that does not routinely index its tax brackets for inflation. At least in the United States and Canada, federal tax brackets are indexed. (State/provincial tax rates are another story.) As a result of the Australian arrangement, household incomes are now being squeezed by higher tax payments than net interest payments. The RBA is certainly aware of this issue, as it regularly publishes graphs showing this in its monetary policy statements.
The consequence of both differences is that, despite significant population growth, real household disposable income is currently shrinking and is likely to continue shrinking for some time. The household sector is being squeezed in ways unlike any other. So it’s understandable that policymakers here would make different choices.
Finally, the Board will recognize that there is little benefit to making rates more aggressive. Documents released under FOI in May show that RBA staff regularly model the likely outcomes of different paths to the cash rate. A note written in January included in that release modeled the impact of the cash rate path based on the actions of the RBNZ and Bank of Canada. In the current situation, where much of the inflation spike reflects supply shocks, it turns out that there is little benefit to taking a more aggressive path from the perspective of getting inflation back on target sooner. However, it comes with significantly higher unemployment rates.
The memo also indicated that market pricing at the time implied that both the RBNZ and the Bank of Canada would cut interest rates by now. Obviously things have changed since then. However, this highlights that the success of aggressive tightening will depend on policymakers being able to change course at the right time. Otherwise, we could maintain tight policy for too long, resulting in inflation below our target without any real benefit. If you are humble enough about your predictive abilities, you won’t count on getting the timing right at that tipping point. This situation will give more weight to strategies closer to those chosen by the RBA. Meetings beyond February are still possible, depending on the outcome of inflation, but the RBA needs to understand that it is not following the template set by other countries.