Bill Evans is betting on the interest rate apocalypse
Mwahaha. Westpac is all-in on the interest rate apocalypse. Personally, I consider this call nonsense and the RBA will look like a complete idiot if he ever flips again, but if the shoe fits…bring ruin!
The September quarter inflation report was such a surprise that we believe the Reserve Bank Board will decide to raise the cash rate by 50 basis points at the next Board meeting on November 1.
The quarterly CPI print was a 1.8% increase for the trimmed average (the accepted measure of core inflation) well above market expectations of 1.5%. Adjusted average annual inflation reached 6.1% per year. It is the largest quarterly and annual rise in core inflation since the ABS began producing estimates in 2002. Historical estimates compiled by the RBA show the quarterly rise to be the largest since 1988.
Of particular concern is the widening distribution of earnings across index constituents. We see that 90% of expense items increased by 2.5% or more during the quarter. This compares to just 63% at the peak of the mining boom.
During this period of rising inflation, we have been very concerned about a strong inflationary psychology that is rooted in the Australian psyche. As this develops, companies become more confident that they can raise their prices; consumers increasingly accept such action and see significant wage increases, in the context of tight labor markets, as necessary to compensate, supporting the whole process of inflation.
Evidence from the survey that pricing power is pervasive across all expenditure items should be of considerable concern to an inflation-targeting central bank.
Budget documents have raised the prospect of a more than 50% increase in electricity prices in 2023. This means that headline inflation will remain higher and put further pressure on the psychology of inflation.
The best way for the central bank to break this link is through strong rhetoric and action.
The Board should also be concerned about the unusual nature of this cycle as the economy emerges from the pandemic. Labor markets are unusually tight while the household sector has accumulated significant savings that can cushion higher rates. Business survey data indicating that business conditions and capacity utilization are remarkably strong also point to unusual resilience.
We don’t think the Board got into a corner with its surprise hike of 25 basis points below expectations at the October meeting. Note the last paragraph of the October board minutes: “The magnitude and timing of future interest rate increases will continue to be determined by incoming data and the board’s assessment of the outlook for inflation. and the labor market. »
This provides ample justification for accelerating the pace of increases in response to a large upside shock to the inflation outlook.
It seems very likely that the RBA staff, which provides a comprehensive forecast update for the November meeting, will raise its inflation outlook significantly.
We would also expect stronger indications from the RBA Governor’s decision statement on the outlook. He is likely to place more emphasis on his clear determination to bring inflation back to target rather than the current message of a balance between meeting the target and keeping the economy “in balance”. Perhaps the line “Members saw this path to achieve this balance as a narrow path clouded with uncertainty” may not appear in the upcoming narrative.
The discussion of policy deliberations in the October minutes highlighted a close decision between the 25bps trajectory and pursuing another 50bps move with “finely balanced arguments.”
When considering the case for a 50 basis point move, the Board noted that:
“Inflation was high, widespread and expected to rise further” and that “If the Commission reduced the magnitude of the rate hike…. [T]its power in turn provokes an unnecessary reaction of inflation expectations”.
The Governor clearly recognizes the risks of embedding an inflationary psychology into the system.
We highlighted in an “Unintended Consequences” note (October 14) that there had been a significant increase in consumer sentiment and house price expectations following the decision to switch to a 25bp move. .
With the markets and the media, as of this writing, not embracing the prospect of a 50 basis point move in November, one can expect an appropriately negative impact on confidence from a decision to go 50 basis points.
If the inflation report had been in line with expectations, it would have been appropriate to continue the sequence of 25 basis point moves. But failing to respond firmly to this real shock would risk giving the impression of a central bank less than fully committed to the task of inflation.
This would risk further entrenching a psychology of high inflation in the Australian economy.
The level of interest rates does not seem to be a major problem for the Council.
When considering the October decision, the Council described the cash rate, which at the time was 2.35%, as “not at a particularly high level”. With the rate now at 2.6%, there is still real uncertainty as to whether the Council considers this level to be above “neutral”.
The Governor has qualified as “neutral” a positive real cash rate, the nominal component being valued at 2.5% – a nominal cash rate above 2.5%.
A recent speech by Deputy Governor Ellis laid out the RBA’s neutrality estimates in more detail – the conclusion from nine separate models used to generate estimates is that the average neutral rate appeared to be around 1% real or 3, 5% nominal. But the deputy governor stressed that the neutral concept was most useful as a long-term guide and was not mechanically applied to policy, like the real concept of ‘short term’ and ‘long term’. deployed at some point by the federal government. Reserve.
A decision to push the cash rate to 3.1% would certainly, in our view, place policy firmly in contractionary territory, but the academic discussion is not definitive.
The Board’s decision to only raise rates by 25 basis points in October was also partly to gauge the effect of the large cumulative increase to date. Without the inflationary shock, which was a defensible position, but given the risks to the psychology of inflation we outlined above, this strategy no longer seems appropriate.
Going forward, after the 50 bps move in November, we expect a further 25 bps move in December, but with no meeting scheduled in January, there will be a two-month break to allow time for assess the cumulative impact of rapid rate increases.
By the time of the February meeting, the board will only have raised the cash rate by 25 basis points in the previous three months since the November decision – an adequate and appropriate break.
We were impressed with the argument in the October Minutes that: “Delaying policy adjustments would also help keep public attention focused for a longer period on the Bank’s determination to achieve the goal of ‘inflation. This is a reasonable view in an environment where inflation is gradually declining while remaining above target, but not when inflation, as we saw in the last report, is soaring.
The wording of the minutes placed more emphasis on the global economy than we have seen in the past. The concluding paragraph states that: “The Board will continue to monitor the global economy, household spending and wage and price setting behavior.”
Recall that the meeting took place at a time of enormous volatility in the financial markets associated with reactions to the British mini-budget. These concerns have largely subsided. Recent GDP data out of China also beat market expectations. While there are undoubtedly justifiable global concerns, the immediate issues that were likely to have framed the Council in October have subsided.
We are obviously very concerned about the possible impact of these policies on Australians. Undoubtedly, the Reserve Bank shares these views.
But globally, central banks have correctly signaled the dire need to get inflationary pressures under control – a delay in achieving this will only lead to unnecessary additional pain later – as Australia has experienced. during the deep recession of the early 1990s after its failure to solve the inflation problem in the 1980s.
The inflation report made it clear that Australia is no different from other countries. Inflation in Australia is expected to overtake US inflation by the end of the year.
The RBA faces the same inflation challenges as other central banks.
A decision to accelerate the rate hike cycle in November is the appropriate action.
In fact, the inflation report pointed out that Australia is completely different from other countries. Here, inflation is entirely in goods driven by energy and imports. In other DMs, all services depend on wages.
This is a major oversight by Bill Evans. Supply-side inflation is best tackled through fiscal measures.
That said, if your tax authorities are idiots, then the central bank can be run dry…