NAB Monetary Policy Update – October 2021

NAB re-affirms its 2024 rate call and expects economic activity to rebound strongly as restrictions are eased.

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Overview

We continue to expect the RBA to remain on hold until early 2024 in contrast to market pricing which sees a rates “lift-off” by August 2022. Although we expect economic activity to rebound strongly as restrictions are eased, we see price pressures building more gradually. The RBA has been clear that it wants to see actual inflation sustainably within the 2-3% target before hiking, with the sustainability judgement requiring “several” quarters of at target inflation and forecast to remain within the band with wages growth of at least 3% key. NAB sees inflation sustainably at target by the end of 2023, which paves the way for a rate hike in early 2024. In the near-term measured inflation is likely to be buffeted by supply-side disruptions as well as by government subsidies. We expected these impacts to be largely transitory and a clean read on inflation pressures may not occur until mid-to-late 2022. The RBA’s commitment to the April 2024 YCC target also remains with the RBA today buying $1bn to defend the target. That said, headlines of inflation pressure internationally and other central banks hiking will continue to see markets challenge the RBA. However, Australia’s starting point is very different to other countries given subdued inflation and wage dynamics prior to the pandemic, and the fact it will take some time for widespread inflation pressure to emerge. NAB continues to see the RBA lagging the Fed, BoE and RBNZ in normalising rates as the impact of the pandemic fades.

Prolonged lockdowns in Sydney and Melbourne have disrupted the recovery in activity through 2021 but we expect a solid rebound in Q4 and Q1 2022 with above trend growth continuing through the back end of 2022. We expect growth in 2023 to return broadly to trend. The impact on the labour market is also expected to be short lived, but recovery will be with a slightly longer lag than activity where we see the pre-lockdown level of GDP fully recovering by around mid-next year. Note the unemployment rate will be an unreliable measure of spare capacity in the near-term, with the metric impacted by large changes in labour force participation. As workers return to the labour market and participation rebounds,
the unemployment rate will initially rise before resuming its downward trajectory, ending 2023 around 4.0% – around most current estimates of “full employment”. It is for this reason the employment-to-population ratio will be more reflective of labour demand and the overall level of spare capacity in the labour market in the near-term.

While we are optimistic on the activity side of the economy, we do not see an immediate translation to stronger sustained inflationary pressures. Inflation is likely to only lift sustainably once there is a generalised pick-up in wage growth – a likely gradual process given wage bargaining dynamics and a soft starting point. That said, measured inflation may well be boosted in the near term by the impact of unwinding pandemic responses as well as ongoing disruptions to supply chains, elevated shipping costs and pockets of labour shortages. However, it is important to remember that under an inflation targeting regime the key concern of central banks is the general level of inflationary pressure, not relative price changes.

Given that these factors are transitory, the primary concern would come via rise in inflation expectations and hence stronger wage dynamics. For now, the RBA’s assessment is that inflation expectations remain anchored around the inflation target.

In addition to the weak starting point for inflationary pressure the RBA also restated its focus is on actual outcomes – that inflation will need to be sustainably within the band and that “this is not deemed as just crossing the 2% threshold”. In addition, the Governor has acknowledged they are willing to bear the risk of a temporary overshoot of inflation should they fall behind given the usual 18-month lags of monetary policy. Indeed, as part of the “sustainably within the band” criteria, actual inflation will need to be above 2% and forecast to stay there.

While our view is very much aligned with the current guidance of the RBA, given the current/looming moves of a number of central bank peers, it is likely that markets will continue to challenge this – both in terms of the timing of the first cash rate move as well as the yield on Apr-24 bonds (for which the RBA is targeting a yield of 0.1% as part of Yield Curve Control (YCC))s. However, it is important to remember that both domestic and global factors are important in setting monetary policy. While Australia is not immune to many of the current price pressures playing out globally, the starting point for domestic inflation is much weaker. With wage growth having softened and growth slowing in the leadup to the pandemic, it is likely we face a higher degree of spare capacity. Also, the assessment of both full employment (expressed in unemployment rate terms) and the neutral cash rate are both lower than pre-pandemic suggesting more spare capacity and a tighter policy stance than was thought in real
time.

In our view the key risks around our outlook are the point at which labour market tightness will generate wage growth as well as the uncertainty of the timing of the passthrough to consumer prices. While we see
unemployment falling to the low 4s, it has not been at this level for well over a decade and therefore the point at which wage pressure emerges is highly uncertain. That said, slowing wage growth prior to the pandemic as well as the international experience suggests that an unemployment rate consistent with full employment could well be somewhere in the 3% range. On price pressures, we may also observe that firms are able to pass on increased costs more quickly while demand remains elevated – particularly on the goods side – as compared to the pre-pandemic experience where strong competition and soft consumption growth saw greater pressure on margins and only modest price increases. However, as the economy opens up, we expect consumption patterns to normalise – with spending on services to recover over time but demand for goods to ease.

Our core views are:
• The first cash rate hike will occur in early 2024. We see the first move as lifting the cash rate target by 40bps to 0.50%; this is to allow normalisation of the ES rate corridor and would see the actual cash rate trade close to 25bp (i.e. it would effectively be a 25bp rate hike). Following this, we see increases of around 25bps per quarter – a fairly rapid normalisation as the RBA again becomes forward looking. By late 2025 we expect the cash rate to trade around 2.00% depending on the degree of excess liquidity in the cash market.
• QE will be tapered further with another 3-months of purchases at a rate of $2bn a week to be announced in February 2022 once the current tranche ends. We see the RBA ending the program after this final taper, with purchases effectively totalling around $110bn from here. At this point we do not expect the RBA to either unwind the balance sheet by selling bonds on the open market or to reinvest maturities. Rather we expect the RBA to let the balance unwind over an extended period as bonds naturally mature. This will have two impacts,
o Firstly, it will gradually drain liquidity from the system as the government repays the RBA.
o Secondly, it will lead to a steepening in the yield curve (a tightening in monetary conditions) as the
government refinances RBA held maturities with new issuance in the private market.
• We see the RBA as remaining committed to the YCC target of 0.1% for the April 2024 bond.