Australia has been delivered another rate hike in an attempt to "quash" inflation. This month Darren debates with special guest Tim Toohey, Head of Macro and Strategy, the risks posed by rising wages and weak productivity growth, and why the RBA continue to change its goalposts to drive down inflation.
Australia has been delivered another rate hike in an attempt to "quash" inflation. This month Darren debates with special guest Tim Toohey, Head of Macro and Strategy, the risks posed by rising wages and weak productivity growth, and why the RBA continue to change its goalposts to drive down inflation.
Hello and welcome to the Rake Debate. I'm Darren Lange, co-head of Fixed Income at Yarra Capital. Joining me today is Tim Tuye, yarra's Head of Macro and Strategy. Welcome to the Rake Debate, tim. Thanks, darren, good to be here. Well, it's the first Tuesday of June and that means the RBA has just met And, as was partly expected, the RBA has increased interest rates of further 25 basis points to 4.1%. You know, looking at the statement, this is probably the most consistent statement of the last four. It actually seemed to be pretty much in line with the previous one. I don't know, tim, was there anything in particular that caught your attention in today's statement?
Speaker 2:I think the thing that was probably most interesting about it is they're still focusing very heavily on productivity and your labor costs. There's been the really big thing that is worrying them looking forward And they're still, i think, looking offshore a little bit and referencing that and applying that locally. So there has been a bit of a change, i think, in the last two months, to what they've been calibrating policy around. But in the statement itself, i don't think there was too many surprises in it.
Speaker 1:Yeah, it's interesting about productivity. I mean, it's one of those things that I think probably most people don't understand. given we've got you here today, Do you want to give us your quick introduction to what productivity actually means?
Speaker 2:Well, I think we need to put it into context of what they're looking at. So I mean productivity is broadly defined as, obviously, how much output is being put out in the economy, either on an hours work basis or per employee basis. So it's important because when the RBA goes about thinking about modeling inflation, it's heavily dependent upon year labor costs. So year labor costs are a function of output, they're a function of productivity and they're a function of wages. So we've seen the RBA really shift their language around prices and wages this year, all year really, and I think that's been the really important development And they've sort of waxed and waned a little bit.
Speaker 2:There was a lot of talk from the RBA not much from anybody else, to be perfectly frank outside of the RBA, but around the idea that there was something of a price wage spiral that could come about this year.
Speaker 2:And we saw that really in February and it really set the Dove's scamper rate. I think the language is something like you know, there's a real importance of avoiding a price wage spiral. It's interesting they switched the order from what we normally talk about as economists as a wage price spiral. So there was something in that implying causality would run from wage earners trying to keep up with cost of living pressures, rather than the more familiar 1970s type experience of cost push inflation which was basically feeding back into wages. Nevertheless, it provided a real cathartic shock for rate markets very early on in the year. But by March they suddenly sort of reverted form. It had a bit of a change of mind and they acknowledged that wage growth wasn't really continuing to pick up with response to the tight labor market. Wages are still sort of consistent with the target And, if anything, they were acknowledging that recent data had really sort of stepped them back from that idea of a price wage spiral.
Speaker 1:Do you think the recent increase to the minimum wages and to the award wage agreements has had anything to do with today's decision? Well, it creeped in there a little bit.
Speaker 2:They did talk about a pick up and award wages, but again the message there was wages are still consistent with the inflation target. The general story is, i mean, if you want to break it down a little bit, i mean wages are running at 3.7%. Productivity is running a little bit under 1% on a net 10-year sort of average basis. Now there is a really big danger in many ways for a central bank trying to fine-tune ownership policy towards the top of the cycle with something as as hard to measure and as volatile as productivity.
Speaker 2:Because typically what you're doing when you're hiking rates and you're slowing demand growth in the economy, by definition productivity is going to slow, if not decline, by virtue of the fact that output slows faster than your inputs near labor and capital. By definition, labor costs actually accelerate into a downturn. The problem that God is a central bank is actually that their main forecasting model uses by far and away the biggest input into it is labor costs. So they're looking at their model saying that, oh look, inflation is going to be a problem because labor costs are accelerating quickly, but it's actually an artifact of the fact that they've slowed private demand so sharply. So we're going to get GDP tomorrow It's probably going to be about 0.3. Private demand is going to be running about 1% year on year and still slowing obviously. So we're getting very close to that flatlining of growth type environment and that becomes pretty precarious.
Speaker 1:We've spoken about this several times, but central banks have a tendency to overcook rate rises anyway. I think this time is probably going to be exactly that. One of the truly interesting things I thought in the statement again was that they made this comment about services inflation being sticky, but they mentioned only in terms of offshore. It seems a bit unusual that they would be that concerned about necessarily an offshore phenomenon which may not be happening here as a reason for tightening interest rates. But are we seeing services inflation here being quite as sticky as what's happening offshore Again?
Speaker 2:it's a bit of a danger in just referencing what's happening in services inflation say the US and then applying that locally. So typically when we think about services inflation we think about 85% of that has been driven by labor costs, And in the UK, in the US, in a large part of Europe, wage growth is just in a different postcode to what we've seen locally. There's also just quirks in the US. Insurance, for instance, really gets into the services inflation on an annual basis and it resets. At the moment it's all about healthcare costs, which is a peculiarity of what's going on in their system at the moment. That's really been the factor that's been accelerating recently in driving services inflation in the US. And there's also something that's probably a lot of people don't realize but about 20% of the US inflation basket is public administrative prices And most of that is set with a one year lag on what inflation was. So strong inflation last year permeates through into public administrative prices this year. Again, you need to be a little bit careful about just extrapolating. So again, wages are nowhere near as strong. We don't have the same sort of peculiarities around the way we measure services inflation, But one thing that the Fed in particular has been doing is saying, yeah, we're concerned about stickiness in inflation, but let's look at it exousing.
Speaker 2:We're thinking about it as core core services inflation is the phrase they tend to use, And that's important because rents are a massive part of their basket. It's about 33% of headline and about 42% of core inflation in the US. It's a huge component. It would make sense for the RBA to do something similar here, but it would also make sense to think a lot more about how public administrative prices are really holding up our own services inflation, Because, if you think about it, a lot of it is utilities, obviously. A lot of it is rates, a lot of it is healthcare, a lot of it is education. These things are not economically sensitive to whatever the RBA does month to month.
Speaker 1:Yeah, i thought that was one of the other things that was interesting in today's statement is there was absolutely no mention of rents at all, but they're back on the whole house price case. And then again this thing about the some households have buffers, some don't have buffers. It's causing some sort of inequality. I'm not really sure how they think putting interest rates up is going to fix that particular problem, but house prices seem to be driven at the moment a little bit more by lack of supply rather than any real problem in terms of people getting big pay rises and things like that and being able to afford to pay more. Amen, is the RBA barking up the wrong tree with house prices?
Speaker 2:Yeah. So we saw that last month that it came into one of the factors as to why they rose. Basically, they put out a couple of new ones. I mean, one was clearly the house price aspect, one was the service, the site inflation aspect. One was the $8 as well. We might even touch on that briefly, but when the $8 is essentially unchanged, the trade-weight advice is the middle of last year, so I'm not quite sure why that was relevant.
Speaker 2:The fact that they're picking on house prices well, the reason why a central bank normally talks about house prices is they talk about it because they think it provides an insight into the wealth effect, which typically is very small in terms of its impact on consumption and therefore aggregate demand. And they also think about it in terms of what does it mean for loan growth. Well, we know that housing fund hits approvals are incredibly low and loan growth is pretty anemic. And of course we know that the consumers in more trouble than the early settlers at the moment. So a marginal pickup in house prices should still well down year on year anyway is really trivial to the monetary policy decision, or should be. So it was interesting that they chose to elevate that as a real issue for why we may need to go further. I think it's a little bit of a smoke screen. People understand and follow house prices to some degree, but that's very hard to explain the dynamics around unit labour costs and productivity as to why rates or the neutral rate may need to be higher. The bit around what you mentioned about the supply side and it's super important Now we have a nationally funded body that their only objective is really to try and forecast housing supply.
Speaker 2:They have a very decent shortage of housing estimated into 2025, but it's based around the view that the RBA cash rate was going to stay at 3.1% at the start of the year and net migration was going to run at half of what we're currently running at. So up-dated inputs would see a very, very big shortage of housing in the 2025. Increasing interest rates? well, what does it do? Well, the most economically sensitive part of the Australian economy by margin is housing approvals, so it really does lower the future supply of housing. It becomes a very circular argument very, very quickly. So, again, they would be better served to think about monetary policy really ex-housing rather than trying to solve for something by lower, trying to make room, if you like, for higher rents by crushing the rest of the economy makes no sense.
Speaker 1:Yeah, i think too they've talked about the fact that they'd like to see, or maybe not like to see, where they think unemployment needs to be higher. I guess the more damage they do to their housing market, they should be perhaps careful what they wish for, given that it's a fairly large employer as well. I must admit. We've talked about this a few times before and they do seem to be changing the goalposts month by month. I mean, if you had to sort of, i guess, look forward, what are the key things you think are really important to sort of say, okay, the RBA needs to go again, or I think the RBA is done now?
Speaker 2:Yeah, well, i think they should have been done already, darren. So I really don't think there's going to be too much that's going to come through in terms of an orath and the very, very near term that's going to really surprise us and say, well, actually the RBA really do need to keep going. So the main things that the central bank is really on watch for is a breakout of inflation expectations. It's been a really big part of why the Fed engaged when they did and did what they did over the last year and a half. We just have not seen that same sort of dynamic play through here. And although there is a lot of press and a lot of trees cut down and articles written around, say, the Fair Pake emission outcome it allowed about three tenths of 1% to wage growth, so it is higher than what it was last year, but it's kind of trivial in the context of overall wages growth, which by the RBA's own emission is not a big deal anyway.
Speaker 2:We'd have to be really surprised around what happens with the consumer housing demand, private investment and maybe even government demand to really, i think, come to the view that much more is required And the evidence just isn't pointing in that direction when we're seeing some quite weak retail type data sets. I mean we six month annualized retail's running at zero in nominal space. It's obviously declining in real space. Big downward surprises on housing approvals. We've seen this ongoing recession like outcomes around consumer sentiment. Business indicators are rolling over. We've seen some decent profit downgrades in the system And I think the RBA just need to be very careful. Rote hikes are not a linear transformation into the economy. You get some really nonlinear outcomes when you're right against the precipice of going too far And we're very close to that limit, i think.
Speaker 1:One thing I'll probably bring up too. As you mentioned, company profits were off quite a bit from what they have been the last sort of number we got. How do you think that sort of will lead into sort of employment over the next couple of months? Are there much of a correlation between profits and unemployment or is that sort of not really a relevant thing for employment?
Speaker 2:It's actually really relevant for Australia. There is quite a regular rhythm that you can see throughout time and cycles. I mean. So the sort of perverse thing that we have at the moment is really weak real growth and really strong nominal growth, And obviously the really strong nominal growth is still a function of the prior change in the terms of trade. Basically, commodity prices are really driving the lion's share of that. Now we're into a little bit of a commodity price downgrade cycle, but just even holding it at really high levels would see the year on year changes really fall away.
Speaker 2:Anyway, Nominal growth that we've been seeing over the last 12 months is really going to slow dramatically over the next six to nine months. And that's going to be, I think, when things like the equity market that focuses more on the nominal world will come to realise what economists have been seeing in the real data for a number of quarters now. But it also means that businesses and business owners and even employees will see the harsher reality of that. You know, slow and nominal profit growth obviously leads to when you've had not a lot of volume growth obviously leads to a bit of a profit crunch And that's reflected not just in terms of P&L statement, but in terms of people's employment prospects.
Speaker 2:Now the other point about the way the RBA models things. With that labor cost model or Phillips model, you can have rising labor costs and stay steady on inflation impact if the unemployment rate is moving enough. Now, Okay, 3.7%, it's not really moving too much yet, but there are more signs that the labor market is showing signs of weakness. At the same time, labor supply is improving. So there's a much bigger chance over the next few months the unemployment rate actually will start trending to start moving a lot more And out of this range that we've been in for the last six or so months.
Speaker 1:Yeah, i think if you start adding the wave of people coming into the country on top of that, it probably doesn't take too much to actually get it back up into the fores fairly fast. I still don't think four is probably going to worry them too much, but you start getting into the high fours and fives. that's probably not somewhere they really want to be And they've been sensitive to that in the past.
Speaker 2:Yeah for sure. And the trouble is when the unemployment rate starts trending, it rarely just stops, like in the US. It's a really common sort of phenomenon that if you go more than 3.10%, you tend to goa lot and you're in recession Here. it's not quite as rural based as that, but the reality is that we're moving up more than half to 3.25% we end up moving quite a lot as well.
Speaker 2:It looks like the preconditions are there for something more like that this time, and I just have. Personally, i have some doubts about looking at things like the jolt data in the US or job openings here as being a really strong indicator of latent labor demand. These things can evaporate very quickly and there are some strong evidence that they're actually being misreported and stated anyway in the case of the US and to some degree here as well. So I don't see them as being something that central banks should look at and feel a whole lot of comfort around that the labor market is actually still going to be quite fine if we just keep on hiking on the basis of jobs. That may never be filled.
Speaker 1:In terms of offshore, the LBA seems to be taking its lead from what's happening in the US and less so maybe, other markets. How much influence do you think will happen if the Fed actually now does decide to pause for a little bit? I doubt they're going to move to an easing bias, but even pausing will be a fairly big change for them. Do you think that's more likely to stop the RBA tightening further if the Fed does pause, or do you think they're on their own path now?
Speaker 2:No, i think that they're definitely linked into what the Fed's doing. I think, realistically, if you follow Phil Lowe's commentary and the reason why it's felt like it's in these letters, i'm not quite sure It's mainly because the Fed's changed its view as well. So the Fed found itself it's not misinterpreting where they were in the cycle and having to go higher, and it left a lot of other central banks that thought they knew where the Fed's terminal rate was going to be having to recalibrate as well. If the bottom line if you're just going to be really simplistic about it you're looking at real cash rates at zero or slightly positive, then the Fed's already there and with falling inflation, slow inflation, they'll move into steady, high real rates over the next six or nine months. For the RBA the maths are a little bit different, but if the RBA hits its current forecast for inflation into 2024, then we'll have positive real rates at that point as well. Real cash rates. I think that tells you you should be pretty close to the top as well for this cycle. Alternatively I mean I, as you know, darren, we do our own financial conditions indices. With these last three rate hikes from the RBA, we've now moved financial conditions in Australia firmly into the restrictive zone.
Speaker 2:It's taken us a while to catch up to the Fed, but the Fed has really set and continues to talk in that language. That narrative is always around financial conditions. They've got it to a situation where it's clearly having a depressing impact on economic growth, if not the labor market. Yet I think we'll actually have it on the growth side first and we're still waiting for that material movement in the labor market, but I do sense it's not that far behind now. There are some real parallels to the way the RBA has been copying and chasing the Fed, both in terms of its language, both in terms of this talk around productivity and your labor costs, the inflation expectations component and, of course, financial conditions. The language is very similar and hence the path has actually been pretty much locked in together.
Speaker 1:One of the things you can maybe be a bit critical of the central banking world in general, but the RBA in particular, is that they've been more reactive rather than proactive. Even when we first started the cycle, i remember you saying that they should have been tightening a lot earlier than they were, yet they were still talking about lower and lower for longer. To some extent the Fed was also caught out a little bit. Now we're around the other way, where they look like they're likely to go too far. The other direction It doesn't exactly give you a lot of confidence of the old don't fight the Fed sort of argument, because you kind of have to. I think from a trading point of view these days is that central banks just don't really seem to have their finger on the pulse quite as much as they used to Do. You think that's a fair view.
Speaker 2:Yeah, i think there's been a couple of things there. One is that when inflation is within sort of bands that would have been used to, the political aspect around monetary policies is not really that visible. In fact, we all champion the independence. but when inflation becomes at such a level that it's a clear national and political imperative, central banks actually start to react a little bit differently, even if they're still pretending that they're independent. the reality is there was massive story for Biden and it was a very big story here on our local election as well. Just needed to come down.
Speaker 2:Central banks are actually thinking about the time frame of what is actually realistic. but it is unusual for central bank to be consistently cutting their growth forecast, which they've been doing for a number of quarters, pulling down their inflation forecasts and still ratcheting up where they see the terminal rate. That's really unusual. Normally they have well and truly done in the tightening cycle when you're in that real downgrade phase for growth and inflation in the forecasting arena. So, yeah, there is something that's different there.
Speaker 2:There's also something that they kind of lost track of their ability to think about where the terminal rate should be. You're probably and this might be a bit too wonky. but the New York Fed has consistently for long periods of time been forecasting where r-star you know the neutral rate for interest rates would be for the US and Europe and Canada, uk and the RBA do with very similar methodology here. Probably you can't do that, we're not. then the data's been so distorted by COVID and the lockdowns and the stimuli So they've only just started to re-estimate that in the US very recently. So they're only, if you like, just starting to set their anchors again for where the model should be able to tell them where neutral is, rather than just trying to fill their way with the data.
Speaker 2:I kind of think that they just they didn't really know where they were going, they didn't know where the terminal rate actually was and they wouldn't want to really put too much weight on where these models actually suggest is right here, right now anyway. but it suggests for the US the real, certainly at the moment the r-stars around one. So they'll be at one if they leave rates unchanged, using what the Fed's current expectation for inflation will be by the end of the year and the current spot rate. So job done in that sense. So locally it kind of works out similar as well, but they should really be done. It's just a matter of whether, as you say, that the goalposts don't change yet again.
Speaker 1:Yeah, and I think that's probably the one message I get from this statement. It wasn't particularly different from the previous ones, so they've left it very open to tightening further if they have to. They've still made it very data dependent, so it's sort of really hard to sort of say I think they should be done. They probably think themselves as they'd like to be done, but if we get a couple more numbers that are a bit ugly, i would suggest they're probably going to go again. But I think it's going to be a mistake in the long run.
Speaker 2:Yeah. So I mean it's interesting is that, though the things that they continued to call out through most of this year we're going to be watching global growth, global data that's been clearly in downgrade mode, particularly aspects around China recently, which normally no reference against China. In this statement today, they were saying they're going to watch the consumer, which is, i would say, universally has surprised people on the downside and we still have had a very sort of conservative, slash, bearish view around the consumer And we're not done on that yet. It's still going to get worse in the next few months rather than get better. They're focused on the business surveys and the consumer surveys and they're obviously deteriorated.
Speaker 2:Yeah, so if they were being, i think, somewhat true to the things they said, they were going to be really looking at and deciding what they were going to do month to month. Yeah, those things have universally been on the downside. There hasn't been anything positive there to talk about. So it's been harder to read the LPA when they're essentially just saying, oh, but we found this other reason, oh, and maybe this reason, maybe a weaker $8, maybe it's a house prices going up a few percent. Yeah, those sort of things don't help when you're really trying to mark out the very top of the cycle. So I don't envy you having to trade this month to month because that's a really tricky part of the cycle to try and do it. But I do think we're pretty close to that summit.
Speaker 1:Well, that's it for this month. Thanks for joining me, tim, it's been a pleasure. Yeah, well, yeah, it was good to be here. Thank you, tune in next month when we'll be joined by Roy Keenan, our other head, co-head of fixed income, to help deliver our latest thoughts on the RBA's July rate decision and provide an update on what's been happening in markets. If you ever want to suggest topics to discuss further, i can be contacted at theratedebate at yaracemcom.
Speaker 2:The rate debate podcast content may contain general advice. Before acting on anything in this podcast, you should consider your own objectives, financial situation or needs and seek the advice of an appropriately qualified financial advisor.