The economy is improving, but much more improvement is needed
The theme for the past few months has been surprising economic strength. This can be attributed to activity bouncing back from its COVID-driven shutdown following the Melbourne outbreak. But very supportive fiscal and monetary policies are playing their role. The result has been upward revisions to expected GDP outcomes for both 2020 and 2021.
There is a growing possibility that the unemployment rate may have already peaked in this cycle. The Federal Treasury has suggested a benchmark of the unemployment rate falling comfortably below 6%. As at the end of last year no state or territory was below 6% (Queensland was well above 7%).
The unemployment rate is not the only measure of how the jobs market is performing. Arguably a better indicator is the under-utilisation rate, as it also takes into account the proportion of employees that cannot work the hours they want because they can't find full-time employment. That measure declined from over 20% in April/May to just over 15% by December. But that year-end figure is still comfortably above its historical average (12.8%).
Surveys indicate that both consumers and businesses think that current economic conditions are a bit above average. Those same surveys indicate that household saving intentions are still quite high. And firms' capex intentions quite low. There is a risk that this caution could continue. COVID-19 followed a period when consumers experienced an extended run of low wages growth, as well as a growing debt burden.
The RBA might be in for a quiet year
What does all of this mean for the interest rate outlook? I think the RBA will look to increase interest rates when the unemployment rate is closer to 5.5%, wages growth is at least 2.5-3% and (underlying) inflation of 2% (or above) for two consecutive quarters.
At the time of writing, financial markets were pricing in a good chance of a quarter percentage point rate hike some time in 2023. This might reflect views of when the economic outcomes nominated above are achieved. But I think financial markets might be a bit early in their current thinking as they could be underestimating how long the RBA will be willing to accept stronger economic growth. The RBA has changed how it thinks about monetary policy. Going forward it will be the actual inflation outcomes that will matter setting for interest rates not their forecast for inflation.
The AUD upward journey has not yet finished
The recent move below 77c is a sign that the Aussie does not want to head higher right now. The impact of COVID on the global economy, delays in the global vaccine rollout and the uncertainty about the size of any fiscal stimulus in the US (and the problems about spending the stimulus in Europe) are taking their toll. Some central banks (notably the ECB) have become worried about the strength of their currency.
But I doubt that we have seen the high of the AUD in this cycle. Delays in the vaccine rollout are only short term. There is plenty of fiscal help still in the pipeline, and interest rates will remain low for some time yet (supporting strong global growth and therefore currencies such as the AUD). China is forecasting higher steel production this year. Sure it will be met by a pickup in Brazilian iron ore supply. But financial markets have been predicting (big) falls in the iron ore price for much of the past two years but the price has gone nothing but up! Providing financial market volatility remains low a break of 78c is possible in coming months, and the possibility that the AUD could hit 80c (and maybe as high as 81c).