The contradiction of RBA’s inflation fears in a slowing economy

The RBA’s forecasts for headline inflation, if realised, would be on par with the experience of the mid 1990s. Picture: Bloomberg

The past month has provided some interesting developments on the economic and policy front.

The context to recent developments is the RBA’s approach to the current tightening cycle, in which it has chosen to embrace the flexibility inherent in Australia’s inflation target by forecasting a two-and-a-half-year descent of inflation back into the 2-3 per cent target band.

This is a more protracted return to the inflation target than many of the RBA’s central banking peers have forecast; indeed, on current forecasts, core inflation is expected to reach 2.9 per cent by mid-2025, while headline inflation is expected to reach 3 per cent by mid-2025.

The RBA’s forecasts for headline inflation, if realised, would be on par with the experience of the mid-’90s, and not as large or as rapid as the disinflations of the early 1980s and early 1990s (both recessionary periods).

The rationale behind this approach was a desire to preserve as many of the gains in the labour market as possible. With the labour market at – or even beyond – full employment, the RBA has actively chosen to preference a smaller rise in unemployment over a faster return of inflation to target-consistent levels. On many levels, this makes sense, given the importance of full employment to society’s progress and overall wellbeing.

JBWere chief investment officer Sally Auld. Picture: Ryan Osland

The one downside of this framework is that it leaves the RBA with no room for error on inflation. Upside surprises to actual inflation or an unfavourable shift in the distribution of risks to inflation forecasts cannot be tolerated.

In this context, the significance of the recent Fair Work Commission decision on minimum wages and the April monthly inflation release is clear.

On the former, the commission awarded an 8.6 per cent increase in the minimum wage and a 5.75 per cent increase in the minimum award wage. These numbers were higher than most expected. And while many will point to the fact that a small proportion of the workforce is covered by these arrangements, the key point is that these numbers operate as a “psychological benchmark” in other workers’ wage bargaining processes.

In the absence of productivity growth, these developments increase the risk that wages growth settles at levels inconsistent with the inflation target.

The monthly inflation number, while a statistically incomplete picture of inflationary developments, was significantly higher than the economists’ consensus. It showed headline inflation at an annual rate of 6.8 per cent in April, compared with expectations of 6.3 per cent.

While the broad trajectory of this series is still consistent with the RBA’s forecast, we suspect the upside surprise may reduce conviction in the forecast path.

In addition, the most recent set of National Accounts showed that unit labour costs – a key driver of core inflation over the long run – had accelerated to an annual rate just shy of 8 per cent. Housing shortages continue to pressure rents, which account for 6 per cent of headline CPI.

And recent news suggests energy bills will rise further in the second half of the year.

When we put all of this together, it is not surprising that the RBA observed at the June board meeting that “ … upside risks to the inflation outlook have increased”. It is worth emphasising that for a central bank that is 13 months into a 400 basis point tightening cycle to be worried about upside risks to the inflation outlook is highly unusual; central banks would be more likely to worry about downside risks to growth at this point in the cycle.

It is also quite striking that the RBA’s risk bias to inflation has changed when it is clear from recent GDP data that monetary policy has gained traction, and that growth momentum has slowed. The economy is slowing, but the RBA is now more worried about inflation than it was only a few months ago. This is an unusual and uncomfortable situation for our central bank.

Given the extent of disinflation required, it was always likely that the RBA’s forecast of a modest 100 basis point rise in the unemployment rate over the next couple of years – one shared by most economists – was too benign.

Recent dynamics are starting to underscore this view as economists lift terminal policy rate forecasts and downgrade their growth and labour market outlooks. As the RBA continues to lift rates and express concern about the inflation outlook, is now becoming clear that the distribution of risks to the soft-landing view are shifting materially to the downside.

What does all this mean for investors? In short, investors should prepare for a meaningfully weaker economic environment in Australia. Whether this is an outcome which will satisfy the technical definition of recession might be interesting, but not overly relevant to investment strategy.

Investors should maintain a defensive asset allocation and favour an “up-in-quality” bias at an asset class level. There are also very attractive yields on offer at present in more defensive asset classes such as government bonds and credit.

The silver lining is that valuations across most growth assets will adjust lower if the economic correction is meaningful. For investors, this is precisely the opportunity that will provide the foundation for solid returns in the future.

So ensuring that a proportion of the portfolio is liquid and ready to utilise at the appropriate juncture remains a wise strategy.

Sally Auld is the chief investment officer with JBWere