A difficult balancing act as the RBA starts raising rates

Kieran Davies

Coolabah Capital

With the RBA about to start raising rates for the first time since 2010, it will be trying to manage a challenging economic mix of very low unemployment and high inflation. The unemployment rate has fallen quickly and is on the cusp of dropping below 4% for the first time since the mid 1970s. At the same time, underlying inflation has accelerated to 3¾%, which is the fastest inflation since the height of the mining boom and well outside the RBA's 2-3% target band.

The uniqueness of this mix is apparent by comparing it with the start of rate hike cycles from the late 1980s onwards.   

  • The labour market is much tighter now in that the unemployment rate of 4% is below the RBA model estimate of the NAIRU of 5¼%. In contrast, the labour market had some remaining slack at the start of recent rate hike cycles, with unemployment above the estimated NAIRU.
    • Even if the model estimate of the NAIRU is wrong and the NAIRU has fallen during the pandemic, the current situation is still different to past rate hike cycles. In particular, if the RBA assumption that the NAIRU has fallen to the high 3s/low 4s is right, then the labour market is probably broadly in balance, which still contrasts with past hiking cycles.
  • The rate of improvement in the labour market stands out, with the unemployment rate falling by almost 2pp over the past year, exceeding the improvements posted heading into past hiking cycles.  
  • Underlying inflation is above the RBA’s 2-3% target band, which was also the case at the start of recent rate hike cycles, although the current outright level of inflation is the highest since the late 1980s. 

  • Underlying inflation has accelerated the most over the past year, contrasting with no reliable pattern in past cycles. 

In managing the combination of low unemployment and high inflation, it is clear that the RBA no longer needs to hold the cash rate at the emergency level of near zero. 

Instead, the RBA will be trying to raise rates relatively quickly to ensure that inflation returns to the target band once the temporary boost to consumer prices from the pandemic-related disruptions fades.  

This could prove a very difficult balancing act.  China's handling of COVID is further disrupting the global supply of manufactured goods, while the local behaviour of wages to the lowest unemployment rate since the 1970s could prove unpredictable, particularly if workers start to push for wage rises to compensate for the higher cost of living.  

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Kieran Davies
Chief Macro Strategist
Coolabah Capital

Based in Sydney, Kieran Davies is Chief Macro Strategist at Coolabah Capital Investments, an asset manager with 40 executives and over $8 billion in fixed-income strategies. Kieran is responsible for macroeconomic research and investment strategy,...

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