The interest rate anchor remains
Over recent months, the economy has been stronger than expected. This has largely been due to the unwinding of many of the COVID-19 restrictions. But it also reflects the massive amount of stimulus being pumped into the economy by the Federal and state governments, as well as by the RBA.
Even if economic growth is strong, the important question is whether it will be strong enough. The under utilisation rate in November was 16.2%. This is almost 4 percentage points below its 2020 peak, but is still around 3.5 percentage points above its long-term average. This excess capacity in the labour market has resulted in wages growth to be at its slowest pace in the past 20 years.
The RBA has made it clear it has two key objectives: to get the unemployment rate sustainably down and the inflation rate sustainably up to their 2-3% target band. A good sign is that the improvement of economic growth has seen financial markets revise up their view about the inflation outlook. Inflation views have yet to significantly change for either consumers or businesses.
The RBA recently made it clear that it intends to keep the cash rate unchanged for at least the next three years. That view might be challenged if the economy continues to surprise with strength in coming months. For now, the combination of uncertain economic outlook and central bank buying should cap any rise of long-term interest rates. But as the vaccine is rolled out over the next year, economic restrictions will be eased further. And there is a mountain of saving (both domestically and globally) that is waiting to be spent. This means that at some stage investors should be prepared for the possibility of higher interest rates.
AUD: How high can it go?
One of the other aims of RBA's recent easing of monetary policy was to have a weaker exchange rate. Since the start of November, the AUD has risen by around 5c. Again, this can mostly be put down to 'good' reasons. The arrival of a vaccine has boosted optimism about the medium-term global economic outlook. This improved optimism has also resulted in a reduction in financial market volatility. The improved optimism and the strong pickup of the Chinese economy has meant that iron ore (and other commodity) prices have risen to very high levels.
But another factor behind the AUD strength is the relative support central banks are giving to their economies. While the cash rate is at very low levels in Australia, it is negative (and likely to stay there for some time) in much of continental Europe and Japan.