The Reserve Bank governor engaged in a fascinating media conference shortly after this week’s RBA board meeting, where he pushed back on the market pricing for a series of interest rate hikes starting in the first half of 2022.
That said, Philip Lowe was open to the idea of ‘early’ hikes to interest rates if the economy unexpectedly showed rising inflation pressures driven by falls in unemployment and a pick-up in wages growth.
It must be emphasised that this was considered to be a low probability by Dr Lowe but in the world where economic indicators and financial markets can move very quickly, it was a wise caveat.
One of the most interesting parts of Dr Lowe’s Q&A session was when he mentioned, several times, that Australia had not experienced an unemployment rate around 4 per cent since the 1970s and, given the massive structural changes in the economy since then, it was not clear how wages would respond in the current era to such a low unemployment rate.
He is partly correct with this assessment.
From around 2003 to 2010 the labour market was tight, with near full employment and a sustained period of strong wages growth.
Some of the facts
In the middle of 2005, the unemployment rate fell to 5 per cent, which at the time was the lowest in several decades. By late 2006, it had fallen to 4.5 per cent and it stayed at or below that level right through to the end of 2008.
That fall in the unemployment rate coincided with a sharp lift in the workforce participation rate from around 64 per cent to over 65.5 per cent. Workers were being enticed to join the paid workforce.
The critical issue at this time was the sustained strength in wages growth. The Wage Price Index rose by an incredible 4.25 per cent per annum, on average, from 2002 through to 2011. It was a near decade of rapid wage increase and, if repeated in the current upswing, would feed into sustained high inflation.
What happened to inflation... and official interest rates?
During this earlier period of rapidly rising wages, underlying inflation was elevated.
From the middle of 2003 through to late 2010, the annual increase in the trimmed mean inflation rate did not once fall below 2.5 per cent, the mid-point of the RBA’s target.
Even more illustrative, annual underlying inflation was above 3 per cent from late 2007 to early 2010 and it spent five quarters above 4 per cent with a peak of 4.8 per cent in September 2008.
It was an extraordinary inflation break-out that many market analysts and even the RBA seem to have forgotten.
The RBA reacted to this inflation explosion firstly by hiking the cash rate by 300 basis points to 7.25 per cent in March 2008, it then cut during the global financial crisis, then hiked again by 175 basis points in 2009 and 2010 to a peak of 4.75 per cent and wage and inflation pressures persisted.
Rate hikes likely in 2022
No-one is seriously suggesting official interest rates will rise to 7.25 per cent in the upcoming rate-hiking cycle.
But in a scenario where inflation hits and exceeds 3 per cent in what is set to be a period of low unemployment, high participation and strong and sustained economic growth, interest rate hikes of 2 to 3 percentage points would appear to be a bare minimum.
In a climate where inflation was to test 4 per cent and remain above 3 per cent for an extended period, it would be reasonable to assume the cash rate would rise by 3 to 4 percentage points.
The next few months will reveal a lot about the likely medium-term path for interest rates.
Once the Delta-lockdown data have passed and more normal readings for the economy, labour market and inflation are clearer, the market and the RBA will have a more concrete basis on which to assess just when and by how much interest rates will need to rise.
At this stage, it remains likely that higher rates will be on the cards for the middle of 2022 and that for the next 12 to 24 months, something near 300 basis points of rate hikes will be delivered.