In focus

Why the market could be wrong about Australian rate hikes


The Reserve Bank of Australia (RBA) was the first to act on coronavirus, cutting interest rates in March 2020. However, we believe that it is set to be one of the last central banks within the G10 to start a hiking cycle, amid a lack of wage growth. At its last meeting at the beginning of November, the bank officially abandoned its yield curve control (YCC) policy. Targeted yields for three-year (April 2024) sovereign bonds were dropped thanks to an “…improvement in the economy and the earlier-than-expected progress towards the inflation target”.

This suggests that the RBA could start hiking interest rates sooner than the date it had previously indicated of 2024. However, we don’t expect it to move much earlier than this, and certainly anticipate the hiking cycle to be much less aggressive than the one currently priced in by markets. At the time of writing, markets are expecting the cash rate to increase by more than 30 basis points next year. We are expecting rates to remain on hold until the second half of 2023.

The RBA kept its other policy settings unchanged at the November meeting. It left the cash rate at 0.1% and the quantitative easing (QE) programme at AU$4 billion per week. It remained dovish, confirming a reluctance to lift rates before 2023. The bank noted it "…will not increase the cash rate until actual inflation is sustainably within the 2% to 3% target range". And, it added, "…this will require the labour market to be tight enough to generate wage growth that is materially higher than it is currently". Any increase in inflation, and therefore in the policy rate, hinges on wages.

Wage growth is central to RBA policy

The RBA believes that in order to see higher inflationary pressure in the economy, wage growth, currently 2.2% year-on-year (y/y), needs to be sustainably above 3%. The bank has been clear that it will not raise the cash rate until this criteria is met, and is prepared to be patient. Even in a scenario in which the underlying consumer price index (CPI) is running at or above 3% y/y, but wages are not adjusting upwards, the RBA is unlikely to act. This is because "monetary policy can't do anything about it [CPI]", said Governor Lowe at the press conference after the November meeting.

Chart1_wage_growth_needs_to_be_above_3.png

As shown in chart 1, salary increases have been stuck below the long-term average of 3% since the end of 2013, contributing to declining inflation over the past few years.

We believe that this trend is set to continue into next year, as we are likely to see only a gradual increase in wage growth in the coming quarters. This reflects the reports from the RBA's business liaison program, where only a small minority of businesses are expecting to give wage rises of more than 3%. Most firms are generally reporting an expected return to annual wage rises of 2-2.5% in 2022.

These reports also highlight that instead of raising base salaries, firms have been using other strategies to attract and retain workers. These have included retention bonuses and increased flexibility.  

Falling spare capacity has not pushed wage growth higher

This helps explain why wage growth has remained subdued despite a tighter labour market. The unemployment and underemployment rates fell below their pre-pandemic levels in the third quarter of 2021, rising again recently on renewed restrictions due to the Delta outbreak. However, wage growth has remained stubbornly low despite the strong recovery.

Chart2_slack_in_the_labour_market_absorbed.png

The latest wage report from the Australian Bureau of Statistics highlighted that salaries are rising at a faster pace in only a few sectors of the economy. In particular, just one of the 18 Australian sectors, professional, scientific and technical services, saw wage growth of more than 3% y/y in Q3 2021. This suggests rising shortages for high-skilled workers.

Lack of labour availability has also been recorded in the construction industry, where salaries accelerated 2.6% y/y over the same period. This is still low and implies negative wage growth in real terms since headline inflation is currently running at 3% y/y. However, wage growth in other services, like accommodation and retail is still below 2.5% y/y. Meanwhile, salaries in the mining sector, despite the significant rise in commodity prices, are still lagging behind, growing only 1.5% y/y.

Forward-looking indicators suggest that labour market momentum will remain positive in the coming quarters. In particular, job vacancies and job advertisements have not only rebounded from their pandemic lows, but they are now running at decade highs, pointing to robust labour demand ahead.

Chart3_labour_demand_set_to_remain_strong.png

Despite higher demand for labour, the prospects for higher wage growth remain dim. As the country reopens its international borders, labour market slack will increase. This will occur as the ability of employers to tap into the global labour market will return.

International boarders are now set to reopen

With Australia’s vaccination rate close to 85%, borders are now being gradually reopened after being shut for more than a year. Government plans for reopening the border for skilled workers and foreign students have been moved forward from mid-2022 to this month. This will help increase the pool of labour available to firms and ease labour market conditions.

Foreign labour accounted for around 4% of the labour force before the pandemic, and so a recovery in migration flows will help ease wage inflation pressures. This could mean that wage growth is likely to continue to disappoint in 2022.

While putting downward pressure on wages, the reopening of borders is also likely provide support to economic activity, particularly in the service sector. This sector had been a big contributor to pre-pandemic growth, representing over 70% of the country’s GDP and employing four out of every five Australian, but has been heavily impacted by the borders closure.

Tourism was the fifth largest export in 2019, after exports of iron ore and coal, but tourism-related exports are still down 70% from its pre-pandemic level. This has dragged on overall service activity, as shown in chart 4.

Chart4_services_exports_well_below_pre-pandemic.png

Fully vaccinated tourists from Japan and Korea were due to be allowed to enter without quarantine from the start of December. This has been delayed by two weeks as a result of Omicron. When borders do eventually re-open, it should favour the recovery in the tourism sector. However, China ranked as Australia’s largest inbound visitor market before the pandemic began. As a result, a meaningful pick up in service sector activity will have to wait until Chinese tourists return to Australia. 

Since 2013, Chinese visitors have outnumbered New Zealanders, historically the top source of tourists to Australia. At 18% of total international visitors in 2019, Chinese tourists represent the largest share, and even more importantly for Australia’s economic development, they spend more money than any other group. Average spending of Chinese visitors in Australia in 2019 stood at more than A$7,000. This was almost double the money spent by Korean or Indian visitors. As a result, their total spending in 2019 for more 30% of total visitor expenditure in Australia, a considerably larger share than any other country (Chart 5).

Finally, we think that trade tensions with China represent a key challenge to the revival of the Australian service sector. They have the potential to delay the export recovery even with an open border, with China warning its citizens not to travel to Australia.

Chart5_average_spending_foreign_visitors.png

Conclusions

With a high vaccination rate that will diminish the probability of more lockdowns, the economic recovery is likely to continue next year. This will allow the RBA to continue to taper its bond purchases in February and end QE in May 2022.

However, markets are likely to be disappointed as the RBA will only lift its policy rate once underlying inflation prints are consistently on target. We think that the conditions for higher rates will not be met until the end of 2023, when stronger wage growth is set to put upward pressure on prices. Therefore we think that Australian government bonds are attractive as yields are too low.

Clearly, the emergence of the Omicron variant increases the risk of new restrictions on activity and further delay in the reopening of borders.

Finally, another downside risk to Australian activity is represented by the expected slowdown in Chinese growth that is likely to act as a drag on Australian exports of commodities.

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