In spite of delta outbreaks and associated lockdowns that are expected to drive the Australian economy into contraction and stall the recovery, the RBA is confident that a strong rebound will follow when restrictions ease. This was the sanguine messaging from Australia's central bank this week as around 60% of the population was in lockdown. In its August quarterly Statement, the RBA outlined that GDP was anticipated to contract by at least 1% in Q3, with household spending and residential and non-residential construction to be hit hard. However, that estimate was made before Melbourne's latest lockdown, announced on Thursday. As a result, the labour market is expected to hand back some of the ground it has made in its recovery, with employment to fall and the unemployment rate to back up a bit from its current level of 4.9%, though a much larger impact is anticipated to be seen in hours worked. But as vaccinations rise, the experiences coming back from earlier lockdowns suggest to the RBA that the economy will rebound when restrictions ease, anticipated to be in the December quarter. This being said, there are clear downside risks given that lockdowns are to remain the main response to outbreaks until vaccination rates rise towards 70% under the national roadmap to reopening. Modeling from the Treasury released this week provided insight into the potential economic impacts going forward.
Although the delta setback has knocked 0.75ppt off the 2021 growth forecast to 4.0%, the RBA sees this as a short-term disruption to the trajectory of the economy as it transitions from the recovery to the expansion phase. This was reinforced by the upgrade made to GDP growth for 2022, from 3.5% to 4.25%. With the forecasts recalibrated to a higher starting point due to the stronger-than-expected pace of the recovery up until the March quarter, GDP is now projected to end the forecast period in 2023 at a higher level than it anticipated in its previous Statement. Ending 2021 at 5%, the path for the unemployment rate was lowered from 4.5% to 4.25% in 2022 before making further progress to 4% in 2023. Meanwhile, for inflation, forecasts in both headline and underlying terms were lifted in 2021 — the former to 2.5% from 1.75% and the latter to 1.75% from 1.5% — though the pace subsequently eases such that it is in line with the 2% lower target in mid-2023, with wages growth only rising gradually over this period.
All in all, with the outlook remaining relatively upbeat over this 2022-23 window the signal appears to be that the RBA is content with its policy settings. In spite of the delta setback and against market expectations, the decision by the Board at this week's meeting (reviewed here) to reaffirm the September start date for tapering its government bond purchases reflects this. RBA Governor Philip Lowe told the Parliament's economics committee on Friday that while the Board had the flexibility to dial up the pace of purchases later on if the economic outlook were to deteriorate more substantially, fiscal policy had recently been ramped up through relief payments to households and businesses and that was the more impactful policy response in the circumstances. It was reiterated to the committee that monetary policy will remain accommodative for a long time to come, with the governor noting that the Board did not expect to be raising rates until 2024.
Also of note this week was a range of data releases. Retail sales declined by 1.8% in June reflecting the impact of lockdowns in Melbourne and Sydney, though volumes lifted 0.8% for the quarter overall (see here). Conditions in the housing market remain strong — house prices nationally lifted by a further 1.6% in July (16.1%yr) according to CoreLogic — but policy stimulus is unwinding following the expiry of the HomeBuilder scheme. Reflecting this, housing finance commitments fell by 1.6% in June (see here) and dwelling approvals were down by 6.7% for the month (see here). Meanwhile, surging commodity prices elevated Australia's monthly trade surplus to a new record high at $10.5bn in June (see here).
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Offshore, expectations around the timing for the Federal Reserve tapering its asset purchases are shifting forward following comments from Vice Chair Richard Clarida and a very strong employment report across all key measures. In July, employment on non-farm payrolls surprised sharply to the upside of expectations coming in at 943k against 870k forecast, with the outturn bolstered by the addition of 119k jobs from revisions over the prior two months. While some caution is probably warranted given that it pre-dates much of the concern from delta, it reflects the strong momentum that the economy has built up with GDP now back above pre-pandemic levels. Employment has lagged significantly in the recovery and is still 5.7 million below its level prior to the onset of the crisis. In that context, the Fed has been reluctant to begin the process of removing policy support until there has been "substantial further progress" towards maximum employment. But as Vice Chair Clarida noted in a speech this week, officials of the FOMC are becoming more confident that the progress in the recovery is approaching this threshold — the July payrolls report undoubtedly in line with that view. As for rates, Vice Chair Clarida's assessment was that the economy is tracking towards being in a position for liftoff to start in 2023, and while that aligns with the median of FOMC members' individual projections (that sees 2 hikes that year), the comments were judged hawkish by markets. But, in the near term, there are still considerable issues in the labour market to work through. The sharp decline in unemployment from 5.9% to 5.4% and in the broader underemployment rate from 9.8% to 9.2% speaks to the strength in labour demand (see chart below), with both the manufacturing and services ISM surveys this week again highlighting issues businesses are having in filling vacancies. But the supply side remains constrained: participation moved a little higher in July to 61.7% but is well below its pre-pandemic level at around 63%. Hesitancy due to the virus, school closures, early retirements and ongoing support payments are cited by the Fed as key constraints and these will take some time to resolve. In the interim, wage pressures are evident with annual growth in average hourly earnings running at a 4% pace.
Chart of the week
Across the Atlantic, the Bank of England signaled that asset purchases would run to the existing schedule through to December, though the process of reducing the size of the Bank's balance sheet is now expected to start sooner than previously guided. In an unchanged decision on monetary policy, the MPC will continue to press ahead with asset purchases, with the current £150bn tranche expected to be completed by around the end of the year. Mindful of the need to create headroom for future asset purchase programs to have similar firepower to previous versions of QE in the event of a crisis, the MPC sees benefit in lowering the stock of assets on its balance sheet as part of the next tightening cycle. Previously the BoE had indicated that this process would commence when its Bank Rate reached 1.5%. Currently, at 0.1%, Governor Andrew Bailey now says 0.5% is the appropriate level, provided the prevailing economic and market conditions allow it. Initially, the stock of asset purchases would roll off the balance sheet by not reinvesting maturing bonds, allowing the reduction to occur "at a gradual and predictable pace". The decline in the level of the Bank Rate to facilitate balance sheet tightening was attributed by Governor Bailey to negative rates being seen as part of the policy toolkit, as well as a judgment that the effect on financial conditions would be less pronounced than in the past.
On the economy, the BoE's latest Monetary Policy Report conveyed an upbeat assessment of the outlook, with the effect of the pandemic expected to gradually dissipate. UK GDP is still expected to return to pre-pandemic levels by the end of the year, albeit around some near-term volatility from the delta variant. In Q2, GDP has been revised up to growth of 5.0% (from 4.25%), but it is then expected to ease back to 3% for Q3 due to voluntary precautions taken with caseloads high. Supported by accumulated household savings and the waning of the pandemic, very strong growth of 6% is projected for 2022 (up from 5.75%) before cooling in 2023 (1.5%). A key change in the BoE's outlook is that inflation pressures are now higher and more persistent in the short term, though this is still seen as a transitory dynamic. The peak in CPI was lifted from 2.5% to around 4% between Q4 2021 and Q1 2022, before slowing to 2.5% next year (from 2%) and again in 2023 to 2% (unchanged) to be in line with the MPC's target. As the MPC noted, this outlook would be consistent with "some modest tightening" of policy over the next couple of years, in line with market pricing.
In Europe, the composite PMI reading for June was finalised at a highly expansionary reading of 60.2, indicating that the recovery is set to accelerate after getting back on track with a stronger-than-expected rise in GDP in Q2 of 2.0%. While delta outbreaks are a risk, businesses across a range of services industries reported strong demand conditions and they also remained optimistic with sentiment readings at high levels. Activity in the manufacturing sector was also expanding rapidly at a 62.8 reading, though the risk here is that momentum slows in response to constraints on the supply side in being able to meet elevated demand. Price pressures remain prevalent as a result and could also act as a speed bump. Lastly, euro area retail sales showed solid growth rising by a further 1.5% in June coming on the back of a 4.1% surge in the month prior as the shops started opening up more widely.
