Out of patience
The RBA is no longer virtue signalling
Consensus has it that the RBA will raise its official cash rate at its June meeting, having by then seen the inflation and wages outcomes for Q1 released on 27 April and 18 May respectively. The Q1 wages release will come just ahead of the federal election on 21 May, no doubt sparking a discussion about real wages growth.
The release of the March CPI in the US means we can update our forecast for the Australian Q1 trimmed mean inflation rate based on the Cleveland Fed’s trimmed mean. As noted here previously, the Cleveland Fed measure has predictive power for the RBA’s trimmed mean given that it applies a similar trim to the global inflation pressures to which Australia is also subject. The model has called the last two local quarterly trimmed mean prints to within a tenth of a percentage point, finally eliminating the Lowe Residual, when the model over-predicted Australian inflation due to excessively tight domestic monetary policy.
The lower-than-expected US CPI print for March leaves the model’s prediction for the local trimmed mean unchanged at 1.2% q/q and 3.4% y/y, the highest rate since June 2009. Having undershot the inflation target for the better part of seven years, followed by two quarters back in the band, the statistical core measures will now be overshooting the target. The RBA will view this as sufficient justification for further winding back its pandemic monetary stimulus through an increase in the target cash rate.
While the RBA was prepared to let core inflation run below target for the better part of seven years, its tolerance for above-target inflation, or lack thereof, will be an interesting test of the symmetry of its reaction function. Historically, there is some evidence for an asymmetric reaction function arising the RBA’s preferences rather than a non-linear Phillips curve, with the RBA putting greater weight on stabilising inflation in expansions than in contractions (though an earlier literature and sample period suggested the opposite conclusion). Lowe’s term is not yet sampled in this literature.
With the Bank of Canada and RBNZ both presiding over 50 basis point increases in their policy rates, there will inevitably be speculation about a similar move here. A 40 basis point hike, taking the target cash rate to 0.50%, would seem likely in June. Restoring the former 25 basis point corridor around the higher target rate would also seem in order in place of the de facto floor system that has been in place during the pandemic.
The Q1 trimmed mean forecast also serves as an input into our wages model, which is pointing to a 0.8% q/q and 2.5% y/y rise compared to 2.3% y/y for the final quarter last year. While the annual rate would still be short of the 3% threshold favoured by Governor Lowe, the quarterly rate annualises above the threshold. The inertia in wages growth will eventually work in the RBA’s favour, although with inflation now running above target, the RBA’s enthusiasm for higher wages growth can be expected to diminish somewhat.
The May Board meeting will see the RBA make a decision on reinvesting the proceeds of future bond maturities. Given Governor Lowe’s longstanding aversion to balance sheet expansion, it is hard not to see the RBA allowing its stock of bonds to roll off as they mature. While the RBA will keep half an eye on bond market functioning, this is unlikely to be an obstacle to balance sheet contraction.
This process is known as quantitative tightening (QT) and will make a contribution to tighter monetary conditions over and above any prospective increase in the cash rate. The RBA first announced a taper in July last year and stopped bond purchases altogether in February this year, effectively bring an end to QE. That in itself was a tightening measure, but QT will put QE in reverse. We have much less experience of QT than QE internationally. The Fed had barely made a start on its post-financial crisis QT efforts when the pandemic hit. But we should assume the effects are broadly symmetrical with QE.
As we have highlighted in the past, QE has both static liquidity effects and dynamic income effects. The static liquidity effect puts downward pressure on bond yields, so QT could be expected to raise yields, all else equal. But the dynamic effect of QE was to raise bond yields due to expectations of higher future inflation and output. As I noted in my USSC report in 2019, the quasi-natural experiment that arose from the stop-start nature of the Fed’s post-crisis QE program suggests that the dynamic income effect dominated. Yields rose during QE episodes and fell during the intervening periods.
In the middle of a bear market for bonds, it is hard to think of QT lowering yields through a dynamic income effect, but the recent yield curve inversions in the US suggest this is entirely possible. The risk of central banks over-doing tightening in response to supply-side inflation pressures is very real and the yield curve is the canary in the coal mine of perverse monetary policy responses.
Ricardo Reis and his co-authors have a nice analysis of the probability of inflation disasters derived from long-dated inflation swap contracts. The good news is that the probability of a low inflation disaster in the US is small. Given where we were in March 2020, that is a good outcome. The probability of a high inflation disaster is also low, although rising:
Note that the time frames being considered here effectively preclude the high inflation scenario from being due to supply shocks rather than monetary accommodation. So we can view these as being implied probabilities on a monetary policy mistake. For all the angst about the Fed falling disastrously behind the curve, the market is far from buying into it.
I made a guest appearance on Gene Tunny’s Economics Explored podcast to talk about my Mercatus paper on nominal GDP targeting and my Agenda article on the RBA’s pandemic response. The podcast is not up on Gene’s web page yet, but should be available on your favourite podcast app.
My former boss, Simon Jackman, has a page with daily betting market-implied probabilities for Australian federal election outcomes.
Michael Sandifer’s real-time, market-derived US NGDP projection.
The SNB Observatory, a Swiss central bank watchdog, pings the SNB on transparency and accountability, noting the SNB should join the rest of the world in being subject to periodic reviews. Those journalists in Australia arguing against a review of the RBA are ignoring a global trend.