Australia’s strong economic recovery puts RBA’s policy decision under a magnifying glass

The Australian economy continues to perform well. First quarter figures released in June showed a 1.1% y-y growth (1.7% q-q). This means Australia is now one of the only few countries where the size of the economy is either back at or above pre-corona levels. Going forward, we expect the economy to continue to show strong growth (Table 1). Likewise, this positive sentiment is partly reflected in business sentiment index of the service and manufacturing PMIs, which paint a positive picture with values still far above 50.

At the time of writing the “delta variant” is spreading rapidly across the country and imposing new restrictions and lockdowns, especially in the greater Sydney region, Darwin and Perth. The economic impact will potentially be felt in consumer confidence and private consumption, especially in the service sector. This reminds us that Covid-19 will remain a risk as long as there is no herd immunity. More than 7.5 million doses of the vaccine are administered, however due to the new outbreak the government faces a new wave of criticism the relatively slow vaccine roll-out.

Luckily, there is positive news if we look at the labour market. Looking at Figure 2, the labour market has been very resilient in the absence of Jobkeeper. The unemployment rate is down to pre-Covid levels while the participation rate rebounded in May after a minor dip in April, returning close to historic highs. Simultaneously, underemployment is at historically low levels. Furthermore, job advertisements are at the highest point in at least 5 years, up 36.5% compared to May 2019[1]. Part of this increase in job adds might be explained by Australia’s closed borders and limitations in attracting migrant workers. All these factors point towards a tightening labour market.

[1] We have used 2019 figures as the basis for ‘pre-Covid levels’ as comparing the current situation to 2020 would give a distorted view.

So many lights are flashing green with regard to economic performance. As described in our recent report, this raises inflation expectations. So, what will that mean for monetary policy? Everyone is awaiting the much-anticipated RBA policy meeting on July 6th, when the RBA will decide whether to extend the current yield target (April 2024) to the next bond (November 2024) and how it will proceed with the asset purchasing program. The RBA has already ruled out the option of ceasing purchasing bonds in September, but there are still a few other options for continuation, as Governor Lowe mentioned in his recent keynote speech.

The fundamentals as presented in Figures 2 and 3 imply a tightening labour market, which should, in time, lead to higher wages, logically speaking, since logic would dictate that scarcity causes prices to go up. In turn, higher wages should create structurally higher inflation. So much for logic, though, as Figure 4 shows that this effect is still subdued (for now) and that wage growth is still rather low at 1.5%.

This is exactly what the RBA is pointing to when assessing inflation, as it believes that wages need to increase to an undefined but “materially” higher level before inflation can be sustainably within the 2%-3% target band. Nonetheless, it must be mentioned that during the GFC recovery, wage growth was lagging behind somewhat, as can be seen in Figure 4. While the economy continues to recover and rising inflation expectations remain, patience may be the only requirement for wage growth to occur. That would also be in line with the potential outcome of a tighter labour market. However, the RBA has another expectation. Governor Lowe underlined in his latest speech that, due to a strong AUD and international competition, companies might be reluctant to increase prices and will instead focus on cost control, thus relying on non-wage strategies to maintain and attract employees. If that turns out to be true, it could well keep wage growth under pressure for an extended time. The attentive reader will note that there are potentially 2 arguments for sustained accommodative policy hidden in the RBA’s reasoning. And by underscoring the importance of continued business investments as a means to achieve productivity growth, Lowe suggests a third argument: “pick-up in business investment is welcome, but we have a fair way to go to reverse the decline in investment over the past decade. If we are to build the capital stock that is needed for a more productive economy and a durable expansion, a further lift in business investment is required.”

All in all, the fundamentals suggest that patience might provide some of the preferred outcomes. Nonetheless, the RBA’s comments continue to sound a dovish tone, so we wouldn’t be surprised if the central bank continues its ultra-accommodative monetary policy to further spur the economy. Hopefully, the RBA will remember a valuable lesson from the Greek philosopher Epicurus while doing so: “Do not spoil what you have by desiring what you have not; remember that what you now have was once among the things you only hoped for.”