RBA's Lowe May Have to Ignore Weak Inflation, But Not Just Yet

(Bloomberg) -- Australia’s economy is forecast to grow above trend and a burst of hiring is keeping unemployment down. Yet inflation, the last piece of the policy-tightening puzzle, remains weak and shows few signs of life.

That means Reserve Bank of Australia Governor Philip Lowe -- whose board is forecast to keep the cash rate unchanged at 1.5 percent Tuesday -- is unlikely to follow the U.S., Canada and the U.K. in raising borrowing costs just yet. Lowe himself has said he’s not obliged to follow counterparts’ tightening; but that doesn’t mean he won’t if a record-low rate looks completely out of whack.

“If growth continues to pick up, then I think they’ll raise rates long before inflation returns to target,” said John Edwards,  a non-resident fellow at the Lowy Institute for International Policy and former RBA board member.

“My view is influenced by what Phil Lowe’s been saying for many, many months on the perils to financial stability from very, very low interest rates. That was originally an argument for not lowering them any further. But it’s also an argument, as the economy picks up strength, for increasing them.”

Lowe is running a balancing act: trying to bolster financial stability amid precariously high east-coast house prices while encouraging firms to invest and hire through low rates. But he’s also made clear that RBA policy makers aren’t “inflation nutters”, with the governor placing a greater emphasis on asset prices and financial stability when setting interest rates.

RBA's Lowe May Have to Ignore Weak Inflation, But Not Just Yet

Neither economists or traders expect the RBA to shift rates this year. But Goldman Sachs Group Inc. sees next year kicking off with a February hike, with more economists expecting the same in the ensuing months. It’s only in the fourth quarter of next year that their median estimate is for a quarter-point increase. 

Traders, meanwhile, have been pushing back their expectations and now see just over a 50 percent chance of an increase in October 2018, according to swaps data Friday. That climbs to 86 percent in November, the month after third-quarter inflation is released.

Annual consumer-price data released last month showed both headline and core measures came in below the 2 percent lower end of the RBA’s target. Lowe’s two predecessors averaged 2.5 percent inflation over their combined two decades, right in the center of the 2 percent to 3 percent target.

“Inflation shouldn’t need to be at target, or within the target band, before a central bank with a policy rate that is low relative to neutral, begins lifting rates,” said Jeremy Lawson, chief economist at Aberdeen Standard Investments in Edinburgh and a former RBA economist. “But it does have to be very confident that inflation is going to move in the right direction. That, I think, is the critical question.”

The RBA estimates the neutral cash rate is 3.5 percent, some two percentage points above the current level.

Same, But Different

Canada’s rate hike caught markets off guard because inflation was headed in the wrong direction, Lawson said. But the Bank of Canada had to be preemptive because the economy was growing way above trend and it wasn’t appropriate to have policy at an emergency level any more, he said.

“Is the RBA in a similar position? There are a couple of differences,” he said. “First, Canada’s rate had dropped even lower relative to the long-run neutral rate than the RBA cash rate. So arguably it had more to do. Second, at the time, Canadian growth was a lot further above trend than Australia’s is forecast to be. So I still think the RBA has time on its side, particularly after the inflation disappointment.”

Outside inflation, another factor cited against rate rises Down Under is record-high household debt of 194 percent of income. That, combined with record-low wage growth, represents a threat to consumption, and was reflected in retail sales data Friday that showed the weakest three-month stretch in seven years. 

Lowe and his board are concerned that consumers might batten down the hatches and stop spending as they try to bring their debt under control, a major risk given household spending accounts for more than half of gross domestic product.

RBA's Lowe May Have to Ignore Weak Inflation, But Not Just Yet

Edwards, who served on the RBA’s board from 2011 to 2016, said the main impact of the household debt levels will be to make the central bank cautious on tightening. He expects it to increase the cash rate once and then wait and see what happens.

“It’s a good reason not to increase rates rapidly or by big moves,” he said. “I think there are greater dangers in leaving rates very low in a period of increasing confidence than there are in small, gradual increases.” Edwards expects the board will be looking seriously at tightening policy in the first half of next year and perhaps in the first quarter.

New Forecasts?

Three days after the RBA’s board meeting Tuesday, it updates forecasts for growth, inflation and unemployment. In August, the bank predicted growth would accelerate to 3 percent in the year through June 2018, increasing to 3.25 percent in December and 3.5 percent thereafter. That’s well above Treasury’s estimate of the economy’s 2.75 percent speed limit.

Australia’s labor market is also going gangbusters: jobs growth is running at an annual 3.1 percent, equivalent to U.S. non-farm payrolls surging 379,000 a month, according to Sean Callow, senior currency strategist at Westpac Banking Corp. in Sydney. The Australian jobless rate has dropped to 5.5 percent, matching the four-and-a-half year low reached in May.

Lowe, in a late September speech, warned that those who “expect a continuation of low rates of inflation and low interest rates, despite quite low unemployment rates in a number of countries” might be in for a “difficult adjustment.”

During that speech, the governor was asked whether he’d consider raising rates if growth was strong and unemployment falling, but inflation remained weak. Unusually for Lowe, he skirted around the question without answering it.

©2017 Bloomberg L.P.