Inflation, Interest Rates and the Australian Economy

  • Domestic inflation likely to peak in June 2022 according to RBA
  • Strong employment growth boosting Australian economy
  • Australian commodity producers are beneficiaries of Russian export sanctions
  • Australian Exports at record high of $49.2B in January
  • Higher domestic interest rates flagged by RBA
  • Australian investment markets to remain resilient, in face of higher interest rates.

Reserve Bank of Australia View

The message from the Reserve Bank of Australia (RBA) governor is clear – inflation is on the rise. Higher costs brought on by supply chain disruption arising from COVID and higher fuel prices, are the root causes, according to RBA governor Philip Lowe. The interest rate policy response by the RBA depends on whether the inflation spike is considered transitory or embedded in the economy.

At present the RBA sees inflation running at about 3.5 percent and likely to move slightly higher in the short term, depending on what happens with the oil price. The other factor at play, according to Governor Lowe, is the tight domestic labour market. Unemployment is set fall below 4 percent in the months ahead. This level is considered by economists to be the natural rate of unemployment, because at any time, it is likely that 4 percent of the workforce are not available for work. Reasons may include prolonged illness, living overseas, caring for a family member, or in the case of some people, there is simply no desire to work. A tight labour market may create wage pressure as employers compete for workers, pushing wages higher. At present, the RBA consider there is little evidence to support this outcome. For now, Australian wages growth is running at below 3 percent and the RBA consider that future wages growth is most likely to be gradual and moderate. However, the RBA noted that wages growth can accelerate when unemployment is historically low.

The RBA has flagged the prospect of higher interest rates to deal with these emerging signs of rising inflation. The RBA estimates inflation to hit 3.5 percent by June this year, before settling at around 2.75 percent by June 2024. This inflation outlook increases the likelihood of higher domestic interest rates this calendar year. Higher energy prices, which dampen household demand, may require a less aggressive rate tightening; however, this needs to be balanced against the strong employment outlook and the potential for wages growth.

US Federal Reserve Interest Rate Rise 

The US Federal Reserve, being the world’s most powerful Central Bank, has a significant impact on global interest rates. Australia, being an export economy, is hostage to global interest rates because the level of interest rates drives the level of global economic activity. A low interest rate environment creates a buoyant global economy, which in turn buys more Australian exports, including mineral and agricultural products, as well as supporting our tourism and education industries.

So, the recent decision by the US Federal Reserve to raise the Federal Funds Rate to a target range of a quarter to a half percent, has implications for Australian investors. The Federal Reserve (Fed) observed that strong employment growth and elevated inflation levels in the US economy, and the war on Ukraine, which is creating upward pressure on energy prices, justified the rate rise. The Fed stated that it intends to continue raising rates to the same level prior to the global pandemic. It plans to achieve this level by the end of this calendar year. This implies an additional 6 interest rate increases of a quarter of a percent, over the coming 9 months, taking the Federal Funds Rate to 2 percent per annum.

Implications for the Australian Economy

Equity and bond markets around the globe, including Australia, responded positively to the Fed’s announcement of higher US interest rates. The Dow Jones Industrial Index rose by 1.5 percent while the broader S & P 500 Index increased by 2.5 percent and the NASDAQ by 3.7 percent, on the day of the Fed’s the announcement. The Australian ASX200 was up 1.05 percent and the broader All Ords Index up 1.16 percent on the following day.

Significantly, Australian exports in January hit an all-time high of $49.2 billion. This follows the imposition of sanctions on Russia, following its invasion of Ukraine. Sanctions on Russian exports have opened new markets for key Australian exports, boosting demand and prices for Australian exports of Liquid Natural Gas (LNG), iron ore, coal, copper and gold, as well as agricultural exports of wheat, wool and beef. This substantially higher income for Australian producers of these commodities ensures a robust growth outlook for the Australian economy.

History shows that investment markets tend to follow the strength of the economy, not the general level of interest rates. This view is supported by the strong global equity markets immediately post the recent US Fed rate rise announcement.

The strong Australian economy, with near full employment, and supported by record export prices, is well positioned to absorb the interest rate increases that have already been flagged by the RBA and other Central Banks around the world.

The evidence suggests that it will take more than a few interest rate rises to panic Australian investment markets into a prolonged sell-off.

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