RBA ends QE purchases

The RBA Board has responded to Australia's rapidly tightening labour market and higher-than-expected inflation by announcing the end of the purchase phase in its QE program at today's meeting, while the cash rate target was left unchanged at 0.1%. Uncertainty around the evolution of wage-price dynamics means the Board is leaving its options open in 2022, though there was some subtle push back against the aggressive rate hike expectations in markets. 

As was widely expected, today's decision statement from RBA Governor Philip Lowe confirmed that QE purchases will be discontinued. Following a long-awaited review of the program, Governor Lowe cited the faster-than-forecast progress achieved in the Australian economy towards the Board's full employment and inflation objectives and the actions of other central banks in moving away from QE as the factors behind today's decision. By the time the final purchases are made on February 10, more than $277bn of Australian and state and territory government bonds will have been added to the RBA's balance sheet since its inception back in November 2020. Around $80bn of purchases were made in support of the 3-year yield target before it was discontinued late last year. While other central banks are now moving towards reducing the size of their balance sheets, in my preview I discussed the reasons why the RBA has time on its side here. Indeed, Governor Lowe confirmed today that the decision around whether it plans to reinvest maturing bond holdings or allow maturing bonds to roll off its balance sheet has been delayed until the May meeting. 

In terms of the economic outlook, the unemployment and inflation forecasts have been upgraded to reflect recent progress. The unemployment rate is now seen falling south of 4% this year before declining to 3¾% by the end of 2023, the latter marked down from 4% previously. Such a decline would be a historically low unemployment rate for Australia, and the RBA is uncertain how wages growth will respond in that scenario. This will ultimately be key to the inflation outlook. However, for now, the RBA has had to revise sharply higher its inflation forecasts on the back of the Q4 data. Underlying inflation is now seen peaking as high as 3¼% before easing back to 2¾% in 2023 as the pandemic dissipates and supply constraints are resolved. In the November forecasts, underlying inflation was anticipated to gradually lift from 2¼% to the middle of the 2-3% target by the end of next year.

Meanwhile, the GDP growth outlook has been revised lower. The 2022 'year-average' forecast was reduced from 5% to 4¼% in response to the effects of the Omicron wave, but the outlook in 2023 was also cut from 3% to 2%. I'd argue the reduction in the latter is push back against the aggressive pricing in markets for 4 rate hikes this year. The Bank uses the market curve for the cash rate as an input in its economic forecasts. A forecast slowing in growth from 4¼% to 2% in 2023, a pace below estimates of trend growth, reflects the effect of higher rates on activity and hardly seems a desirable situation.  

Today's final paragraph set the scene for Governor Lowe's 'Year Ahead' speech tomorrow and the full set of economic forecasts in Friday's quarterly statement. The RBA is very much in a data-dependent mode and has said it will be patient as the wage and inflation dynamics evolve before determining if a response is warranted. The ending of QE purchases gives the RBA optionality to respond to the upside risks, but the aggressive hiking cycle forecast by markets doesn't appear to be supported in today's statement.   

Australian housing finance resets record high in December

Australian housing finance commitments reset to a new record high at $38.2bn in December, surpassing the peak of the cycle reached in May. The resumption of activity in New South Wales and Victoria that was delayed during the Delta lockdowns has driven the rebound seen over the final two months of 2021. Over the second half of the year, investor activity accelerated to take up the running from the owner-occupier segment following a very strong period of rising housing prices and the withdrawal of construction stimulus.  

Housing Finance — December | By the numbers

• Housing finance commitments ($ value, ex-refinancing) surprised to the upside of expectations (-0.4%) for the second month running with a 4.4% rise posted in December following the 6.3% rebound in November. This took commitments to a record high at $32.8bn to be up by 26.5% over the year. 
• Owner-occupier commitments advanced by 5.3%m/m to $22.5bn (12.4%yr), which came on the back of a 7.6% rise in November. 
• Investment commitments extended their record high with a 2.4% rise taking the monthly aggregate to $10.3bn (73.9%yr).
• Refinancing activity eased by a further 0.6% in December but remains elevated at $15.6bn; a rise of 39.5% on year-ago levels.

Housing Finance — December | The details 

The post-lockdown rebound seen in November (6.3%) extended into December (4.4%) as housing finance commitments took out May's record high; an unexpected development at this stage of the cycle given the withdrawal of the HomeBuilder stimulus earlier in 2021, a modest tightening of loan serviceability requirements and the looming prospect of higher interest rates. Reflecting these factors, commitments contracted by 9.2% between May and October but the past two months have seen that slide reversed through an 11% rebound. 

The driving factor behind this rebound has been reopenings in New South Wales and Victoria after restrictions curbed activity in these housing markets during the Delta lockdowns. Broad-based gains were posted in these two states in December, with owner-occupier commitments up by 3% in NSW and 5.2% in Vic, supported by rising activity from first home buyers (NSW 2.4% and Vic 3.4%); increases in the investor segment were 1.1% in NSW and 3.4% in Vic.  

Taking a step back, the main theme that played out over the second half of the year was the shift from owner-occupiers to investors as the driver of the cycle. Commitments to owner-occupiers fell by 1.7% in Q4 after contracting by 6.6% in Q3. This compares to increases in investor commitments of 7.9% in Q3 and 6.0% in Q4. Whereas rising housing prices have become a headwind to owner-occupiers (and first home buyers in particular) due to affordability pressures they have been a tailwind for investors, as have improving rental market conditions. 

Looking at the approvals data highlights the effect of rising housing prices. While the nominal value of commitments is at a new record high, the volume of loan approvals made to the owner-occupier segment remains well off their early 2021 peaks when the HomeBuilder scheme and first home buyer incentives were supporting demand for loans. However, the unwind in construction-related approvals may be starting to settle. Approvals of this type were up for a second consecutive month in December (2.7%) and are just above the highs seen in the previous cycle in 2017-18. 

Refinancing fell for a 4th month running, down 0.6% in December. While refinancing to the owner-occupier segment increased by 1.4% this was offset by a 4.3% decline in investor refinancing. The chart below indicates we are past the peak in refinancing, but in a low-interest rate environment activity is still at historically elevated levels. 

 

Housing Finance — December | Insights

The extent of the rebound in housing finance seen over November and December has taken many by surprise. The Delta lockdowns look to have been more disruptive to the nation's two largest housing markets in Sydney and Melbourne than previously thought. While now at a record level, housing finance should trend lower over the course of 2022 reflecting affordability constraints, the absence of construction stimulus, and a shift to less supportive monetary policy. 

Preview: RBA February meeting

Today's RBA meeting comes at the start of an important week for Australia's central bank that also includes Governor Philip Lowe's 'Year Ahead' speech tomorrow and the quarterly Statement on Monetary Policy and updated set of economic forecasts on Friday. With the labour market tightening more rapidly than expected and underlying inflation at target for the first time since 2014, the Board is likely to confirm the end of QE purchases today. The cash rate will remain at 0.1% but the RBA may open the door to hiking in 2022, well ahead of recent guidance, should wages growth accelerate. This preview covers the key aspects of today's meeting (decision due at 2:30PM AEDT).         

QE Program

The RBA turned to quantitative easing (QE) for the first time in November 2020 to provide additional monetary stimulus to the economy as it was recovering from the pandemic recession. Nearly $275bn of Commonwealth and state and territory government bonds have been purchased under the program; separately an additional $80bn of purchases were made in support of the now-discontinued 3-year yield target. With Australia's unemployment rate now at its lowest level since 2008 and with underlying inflation at the midpoint of the RBA's 2-3% target band for the first time in 7 years, the time has come for QE to be put back in the toolkit.  

Since tapering the pace of weekly QE purchases from $5bn to $4bn last September, the RBA has stated that it will be reviewing the program at the February meeting. In his final speech for 2021, Governor Lowe outlined that the Board held a preliminary discussion at the December meeting over its options for the program. Its options included: i) tapering further and ending QE in May, ii) tapering but extending QE beyond May, and iii) discontinuing QE in February. At that stage, the RBA said its economic forecasts were consistent with the first option. 

However, discontinuing QE purchases is likely to be announced today given the faster-than-expected progress achieved in the labour market and inflation during the RBA's summer break. Continuing QE to May would rely on the RBA wanting to wait for uncertainty around Omicron to settle, but as was the case during the Delta wave the current disruptions will likely be seen as temporary. Also factoring into the decision will be that many other central banks have either wound up net purchases (BoE, RBNZ, BoC) or have communicated their exit schedules from QE (Fed and ECB). A February finish to RBA QE is consistent with that global shift.  

Economic Forecasts

Before his 'Year Ahead' speech tomorrow (12:30PM AEDT) and Friday's quarterly Statement on Monetary Policy (11:30PM AEDT), Governor Lowe is likely to give an outline of the RBA's updated 'central scenario' for the economic outlook in today's decision statement. From a policy perspective, the forecasts for inflation, unemployment and wages growth are the most influential and these are all in line to be upgraded, albeit with there to be an emphasis of uncertainty around these expected outcomes. An assessment of the impact of the Omicron wave on Q1 GDP growth will also be of interest.  

Recent outturns have shown a significantly lower unemployment rate and higher inflation than the RBA forecast in November. The unemployment rate fell to a 13-year low in December at 4.2%—a level not projected to be reached until the end of 2022—while annual trimmed mean inflation was 2.6% in Q4 compared to a forecast for 2.5% by the end of 2023. This is likely to bring about an uplift to the forecast path for wages growth, with the timing for the key 3% level the RBA has said is needed to sustain inflation inside the 2-3% target band expected to be brought forward from Q4 2023.     

The main uncertainties for the RBA will be how persistent Australia's inflation pressures are likely to be given that many of the drivers are related to the pandemic, while in the labour market the question of how wages will respond to a historically low unemployment rate is unclear. Having been frustrated by slow wages growth over recent years, the RBA has stressed the importance of policy reacting to actual rather than forecast outcomes. With the next update on the Wage Price Index not due until late February, the RBA may be cautious in its outlook.  

  

Policy Outlook 

The RBA moved away from date-based forward guidance for 2024 rate hikes when it removed its 3-year yield target in November. The revised economic forecasts that followed that meeting supported a late 2023 or early 2024 timeline for the first hike. But with this week being about recalibrating the messaging on policy to an upgraded outlook for lower unemployment and higher inflation, positioning the stance to respond to the potential for faster wage and price dynamics is likely to see the RBA leaving its options open to hiking much sooner. Whereas late last year Governor Lowe was pushing back on the possibility of hiking in 2022, the messaging seems likely to soften here.  

With QE purchases set to come to an end, the focus will turn to the process of quantitative tightening. While other central banks are now discussing how they will reduce the size of their balance sheets, the RBA might have time on its side. The first significant tranche of maturing bond holdings does not come up until July, though in any case the unwind of the balance sheet is much more a 2023 story as that is when banks will start repaying the funding they drew down from the RBA's Term Funding Facility. 

Much is expected from the RBA this week considering that markets are aggressively priced for up to 4 rate hikes to be delivered in 2022. However, I think the main messages the RBA will want to get across is that it remains data dependent and that it is now appropriate to have adequate flexibility in the policy stance to respond to the potential for higher inflation. Following the removal of the 3-year yield target and likely end of QE purchases, the RBA is taking another step towards pulling back from pandemic emergency settings.   

Macro (Re)view (28/1) | Hawkish validation

With Australia's underlying inflation rate coming in stronger than expected at 7-year highs and following the significant tightening seen in the labour market, an interesting RBA meeting is in prospect in the week ahead. The RBA's QE program looks set for a mid-February conclusion while an upgraded set of economic forecasts could support a case for rates to start rising later in the year, well ahead of current guidance. Cash rate futures continue to factor in as many as 4 hikes in 2022, but for the RBA an acceleration in wages growth is a precondition and key to the start date. The data this week showed December quarter inflation printed at 1.3% on the headline measure to be running at 3.5% over the year, while the underlying rate was up at 2.6%Y/Y after posting its strongest quarterly rise (1%) since 2008 (full review here).    

Around half of the contribution to annual headline inflation has come from higher fuel prices and rising housing construction costs. The latter has come about due to materials and labour shortages amid a surge in dwelling commencements, while the closure of the HomeBuilder scheme earlier in 2021 means fewer subsidies are now being paid to offset construction cost increases. Pandemic-related factors also influenced inflation in Q4 on reopenings from the Delta lockdowns. Domestic (4.8%) and international travel (16.3%) costs elevated as border restrictions started easing; restaurant prices (1%) lifted in response to higher input costs; while demand and supply imbalances have pushed up the cost of many consumer durable items. While many of these increases are related to the pandemic and should eventually ease, the rise in trimmed mean inflation to 2.6%—the first time the measure has been above the midpoint of the RBA's 2-3% target since 2014—suggests there is now a broader range of effects leading to higher prices. The RBA's interpretation of these dynamics will shape their outlook on policy to be outlined next week.

The December NAB Business Survey reported a sharp fall in confidence (+12 to -12) as Omicron started to spread widely; conditions were holding up for now (+11 to +8) but are expected to weaken in the next survey reflecting the disruption to activity from caseloads and isolation requirements. Indications are that this will put more upward pressure on inflation in Q1, with the December survey highlighting increased labour, input and product prices. Pressure on input costs was evident in Q4 as import prices advanced by more than 5% for the second consecutive quarter and producer prices lifted by 1.3%q/q to their fastest annual pace (3.7%) since 2009. 

— — —

Over in the US, in spite of the ongoing reverberations in risk sentiment, Fed Chair Jerome Powell validated market expectations at this week's FOMC meeting, classifying 2022 as a year in which emergency pandemic settings will be steadily removed. The Committee was true to its earlier guidance in maintaining a March expiry on QE but has markets primed for that to coincide with the first rate hike. The overarching message from Chair Powell at the post-meeting press conference was that curtailing high inflation was crucial to sustaining the economic expansion underway. That expansion now sees US GDP 3.1% above its pre-pandemic level following a 1.7%q/q acceleration in output in Q4. Unlike in previous cycles, Chair Powell said that such was the degree of tightness across a broad range of indicators, a robust labour market could be sustained alongside a path of higher rates. Up to 5 hikes are priced into the forward curve in 2022 ahead of reaching a terminal rate of around 1.8%. The other aspect of this tightening cycle is that the Fed will also be reducing the size of its balance sheet. While the details are yet to be determined, the Fed published alongside this week's policy decision a set of guiding principles for balance sheet reduction. 

Regarding inflation, Chair Powell said a reduced fiscal impulse, less accommodative monetary policy, and some relief of supply constraints should help ease price pressures this year. In December, 12-month core PCE inflation firmed from 4.7% to 4.9%, its highest since 1983. This exceeded annual growth in the employment cost index to Q4 (4%) and there are signs this is weighing on spending. Real personal consumption growth posted its weakest outcome in 10 months with a 1% fall in December. This was driven by weakness in goods consumption (-3.1%m/m) as services were broadly flat (0.1%m/m) despite Omicron. Given the disparity between goods (8.8%Y/Y) and services inflation (4.2%Y/Y), elevated price pressures look to be weighing on demand in the former. 

Other events of note this week underscored the uncertainty markets are currently struggling with. The IMF cut its forecast for global growth in 2022 from 4.9% to 4.4% in its January Outlook citing reduced fiscal support in the US and pandemic restrictions and stresses in the real estate sector in China as the headwinds. This came as the impact of Omicron was reflected in the slowing of the PMIs for the euro area (52.4 from 53.3) and UK (53.4 from 53.6) to 11-month lows in January. Restrictions and precautionary behaviour had weighed on consumer-facing industries in hospitality, tourism and leisure. However, the PMIs were still at levels consistent with expansion and activity looks to have been more resilient to the pandemic than in previous waves. There were also encouraging developments in the manufacturing sector where some of the pressures in supply chains from materials shortages and delivery times had eased. But for the time being, inflation is at elevated rates in both economies and the ECB and BoE have policy meetings next week. Little change is expected at the ECB after its tapering schedule for QE was announced in December, but over at the BoE, a 25bps hike is expected as a follow up to the initial 15bps increase delivered at the previous meeting. This would take Bank Rate to 0.5%, the level at which the BoE has said will see it commencing the process of reducing its balance sheet.  

Australian Q4 CPI 1.3%, 3.5%Y/Y

Australian inflation came in stronger than expected in the December quarter driven by rising fuel and new dwelling costs, while global supply chain pressures and reopening effects post the Delta lockdowns were key contributors. A rise in underlying inflation to 7-year highs points to a broadening of price rises and should see the RBA winding up its QE program at next week's meeting. 

Consumer Price Index — Q4 | By the numbers 

• Headline CPI was 1.3% in Q4, stronger than the 1.0% pace expected and up from 0.8% in Q3. Seasonally adjusted CPI was also 1.3% in Q4. Annual headline CPI increased to 3.5% from 3.0% (vs 3.2% expected) while the seasonally adjusted measure lifted to 3.7% from 3.0%. 

• The underlying CPI measures (seasonally adjusted) printed above consensus and lifted above the midpoint of the RBA's 2-3% target band for the first time since 2014: 

• Trimmed mean was 1.0%q/q (vs 0.7%), with the annual rate up from 2.1% to 2.6% (vs 2.3%). 

• Weighted median lifted 0.9%q/q (vs 0.7%), with the year-on-year rate rising to 2.7% (vs 2.3%) from 2.2%. 

Consumer Price Index — Q4 | The details 

December quarter inflation surprised to the upside as price pressures showed signs of broadening. Headline inflation was 1.3% in the quarter and, as in Q3, was mainly driven by rising fuel prices and new dwelling costs being pushed up due to the fading effect of the HomeBuilder scheme and materials and labour shortages. However, as the chart shows, a broader range of price increases came through than in Q3. Reopening effects from the Delta lockdowns were the key factor behind this as domestic and international travel costs lifted sharply following eased border restrictions, while demand for dining out rebounded strongly and was supported by the NSW government's voucher scheme. Meanwhile, supply constraints and strong demand pushed up prices for many consumer durable items. 

The key CPI aggregates highlight the broad-based nature of the rise in inflation. Headline inflation (3.5%) is stronger than the underlying pace, which mainly reflects the impact of higher fuel prices, but the measures for the latter have risen to their fastest since 2014 and are above the midpoint of the RBA's 2-3% target band. The key trimmed mean measure was up at 2.6% on the back of its strongest quarterly rise (1.0%) since 2008. Core goods prices (2.6%Y/Y) accelerated amid supply chain pressures and core services inflation increased at its fastest in 7 years as the Delta lockdowns ended. Price pressures in traded goods (1.4%) were similar to non-traded goods (1.2%) in Q4, but in annual terms, the former is substantially higher (4.9% to 2.8%) boosted by the resurgence in global energy prices. 

Looking into the key components and the housing group CPI lifted by 1.8% in Q4 and 4% over the year. New dwelling costs surged by 4.2%q/q after rising by 3.3% in Q3. With fewer HomeBuilder grants now being applied against builders' base prices after the scheme ended earlier in the year, construction costs have effectively increased. Materials and labour shortages have also added to price pressures. Meanwhile, the pace of inflation in rents remains subdued at 0.4%Y/Y. Rents in Sydney (-1.9%Y/Y) and Melbourne (-1.1%Y/Y) remain in decline but are rising in the other capitals, notably in Brisbane (7.2%Y/Y) and Perth (7.9%Y/Y) 

The transport group CPI posted a 2.8%q/q rise to be 12.6% higher over the year. Predominantly, this reflects a continued rebound in fuel prices from the depths of the pandemic in 2020. Domestic fuel prices reached a record level in Q4 after rising by 6.6% in the quarter. Over the past year, fuel prices are up 32.3% and have alone contributed one-third of the increase in annual headline inflation. 

As earlier alluded to, reopenings from the Delta lockdowns boosted inflation. In particular, international (16.3%) and domestic travel (4.8%) costs increased sharply in the quarter as border restrictions started easing. Meanwhile, the return of dining out saw restaurant and cafe prices rise by 1% in Q4, though the effect of the NSW government's voucher scheme prevented a larger increase from being recorded. Sporting and recreation activities prices were broadly flat in the quarter, but the annual pace at 4% is stronger than in the years leading up to the pandemic.  

Pressures in global supply chains amid a period of robust demand from Australian households have pushed up prices for consumer durables. Clothing and footwear prices rebounded by 2.6% in the quarter following widespread discounting in Q3 as retailers were trying to clear winter inventory that had accumulated during the lockdowns. In recent years, Black Friday discounting has seen clothing and footwear prices fall in Q4. The global shortage in semiconductors continued to put upward pressure on new vehicle (1.9%) and AV equipment (0.6%) prices in Q4. Furniture and furnishing prices rose at a slower pace in Q4 (1.1%) but are up by a strong 5% over the year.    

Food prices were more contained than anticipated rising by 0.7% in the quarter and by 1.9% over the year. The main reason for this was that fruit and vegetable prices fell further (-0.7%) after Q3's 3.5% decline. Fruit prices were down 1.2% on the quarter on an increased supply of berries and bananas, while vegetable prices softened by 0.4%. 

Consumer Price Index — Q4 | Insights 

There remains a lot of volatility in the inflation data. Around half of the rise in annual inflation can be attributed to fuel and new dwelling costs, while reopening effects were a significant contributor in the December quarter. These drivers will fade over time, but the main point to take out of today's report is the firming in underlying inflation to 7-year highs. At 2.6%, the trimmed mean has reached a pace the RBA's November forecasts did not anticipate until the end of 2023. With the labour market tightening more rapidly than it expected, the RBA discontinuing its QE program in February appears a done deal. Following the lead of many of its global peers, the RBA might be about to turn more open to the idea of raising rates in 2022.

Preview: Australian CPI Q4

Australia's December quarter inflation report is scheduled for release today at 11:30am (AEDT). Annual headline CPI is expected to remain around 3% with fuel and rising new dwelling costs post the HomeBuilder scheme the main contributors. Underlying inflation lifted inside the RBA's 2-3% target band for the first time since 2015 in Q3 and is likely to have firmed further to around 2.4%. A tighter labour market and higher inflation than currently forecast points to the RBA winding up its QE program in February, while it could prompt an earlier start to the hiking cycle.  

As it stands | CPI 

Headline inflation was 0.8% in the September quarter and 3% over the year, broadly in line with consensus estimates. Annual inflation eased from its elevated pace of 3.8% in the previous quarter where it was boosted by the reversal of pandemic-related price falls. 

Underlying inflation picked up in Q3 and came in above consensus expectations. The trimmed mean lifted by 0.7% in the quarter, taking the annual rate up from 1.6% to 2.1% (vs 1.8% exp). The weighted median was also up at 2.1% (vs 1.9% exp) from 1.6% following a 0.7%q/q rise. This meant that for the first time since 2015, underlying inflation had cleared the lower band of the RBA's 2-3% target. 

The main drivers of inflation in the September quarter were fuel and new dwelling costs. Automotive fuel prices lifted by 7.1%q/q and were 24.6% higher over the year reflecting the rebound in demand from the period of global Covid lockdowns in 2020. New dwelling costs lifted by 3.3% in the quarter as supply constraints pushed up labour and materials costs, while fewer government HomeBuilder grants being paid out due to the scheme ending earlier in the year led to an increase in developers' base prices. 

With the Delta lockdowns in New South Wales and Victoria in place for much of the quarter, pandemic-related effects continued to influence inflation. Retail inflation was weighed by increased discounting as retailers sought to clear winter clothing inventory after the lockdowns reduced spending. 

However, supply constraints were putting upward pressure on new vehicle and household goods prices. Meanwhile, services inflation had lifted to its fastest annual pace (1.9%) since 2015. Restrictions on dining during the lockdowns led to a fall in the use of voucher schemes introduced by state governments and this pushed up restaurant prices. Reduced demand from restaurants had weighed on fruit and vegetable prices (-3.5%) in the quarter.

Market expectations | CPI

The consensus for headline CPI is 1% for the quarterly rate, with the range of estimates between 0.8% and 1.2%. This would see the annual pace firming from 3.0% to 3.1%. As in Q3, fuel and new dwelling costs are likely to remain the main drivers of inflation. A post-lockdown rebound in spending could lead to more upward pressure on services inflation. Meanwhile, a reversal of weakness in fruit and vegetable prices is likely to drive a higher pace of food inflation.  

For the underlying measures, the trimmed mean is forecast to rise by 0.7% in Q4, taking the annual rate from 2.1% to 2.4%, while the outcomes anticipated for the weighted median are 0.7%q/q and 2.3%Y/Y. 

What to watch | CPI 

Clear in the memory is the Q3 CPI report that led to significant reverberations in markets and RBA policy. The upside surprise on underlying inflation triggered a very aggressive repricing in the domestic bond market that ended up with the RBA abandoning its 3-year yield target a few days later at the November meeting. If it is now widely expected that the RBA will discontinue the QE program in February, the timing of the first rate hike is in focus. 

Cash rate futures suggest this will come by the middle of the year, but Governor Lowe has pushed back against hiking in 2022 in his recent speeches on the basis that sustaining inflation in the 2-3% target band would require a tighter labour market and faster associated wages growth than the RBA was expecting. 

However, as seen last week, with the unemployment rate falling to a 13-year low at 4.2% in December, the labour market was tightening much more rapidly than the RBA's forecasts. Those same forecasts show trimmed mean inflation to Q4 (2¼%) is a bit lighter than today's market consensus (2.4%). Should the market be vindicated, a tighter labour market and higher inflation than currently expected could see the RBA becoming more open to hiking in 2022.  

Macro (Re)view (21/1) | Moving to higher ground

Ahead of next week's Federal Reserve meeting, markets have responded to the tightening US labour market and high inflation by lifting to 4 the number of rate hikes anticipated in 2022, with the first of those seen in March, while balance sheet reduction is also likely to commence later in the year. Notably, inflation expectations have eased of late indicating that tighter policy will gain traction in slowing price pressures, leaving real yields to push up benchmark bond rates — a headwind for risk assets. US 2-year and 10-year nominal bond rates now sit close to their pre-Covid highs. Domestically, markets forecast the RBA to start hiking rates by June, with cash rate futures pointing to the policy rate reaching 1% by the end of the year. That is a vastly more aggressive path than was being discussed by Governor Lowe in his recent speeches where there was explicit push back to rate hikes in 2022. 

But before the RBA gets to the point of discussing rate hikes, the future of the QE program is to be the main decision taken at Board's February meeting. Though this week's labour market data for December (full review here) pre-dated the Omicron wave, with spare capacity being rapidly absorbed it looks increasingly likely that the RBA will discontinue the $4bn of weekly bond-buying it has been running since September. Following the reopening surge in November, Australian employment continued to rise with a 64.8k increase posted in December (vs 60k expected), which together with eased restrictions supported another sharp expansion in hours worked (1%m/m). From a Delta-lockdown peak of 5.2%, Australia's unemployment rate has come all the way in to 4.2% in December, its lowest since August 2008. Broader measures of labour market underutilisation also fell to 13-year lows. For context, the RBA was not expecting this level of unemployment to be reached until Q4 this year. Weakness in conditions associated with Omicron is likely to be temporary given the resilience shown in the Westpac-Melbourne Institute's consumer sentiment index in January and the strong fundamentals in the labour market with job vacancies elevated and the participation rate sitting just off its record high at 66.1% in December. The effects of a tight labour market on wage and price dynamics is the key focus for policymakers in 2022 and after the upside surprise in Q3's inflation data led to the abrupt end of the RBA's 3-year yield target, next week's Q4 CPI report will be a highlight event.          

In Europe, the account of the ECB's December meeting outlined caution and uncertainty around the inflation outlook. This came as euro area headline inflation was confirmed to have risen at a 5% annual pace to December. At that meeting, in response to an economic recovery gathering pace and rising inflation, the Governing Council announced its tapering schedule that will see asset purchases dialled back from a monthly pace of €80bn to €20bn by October. While the ECB expects inflation pressures to ease through the year, a scenario of "higher for longer" inflation persisting in 2023 and 2024 was discussed. How the outlook evolves will depend on the easing of supply/demand imbalances, but ultimately the ECB sees wages growth as the key influence on inflation. For the time being, wages growth was subdued at around 1.5%Y/Y, but the Governing Council noted that this was a lagging indicator and the longer inflation remained high, the more risk there was that wage and price pressures would build and potentially become entrenched. In the UK, inflation became more elevated in December reaching a 30-year high at 5.4%Y/Y on a headline basis, while the core rate lifted from 4% to 4.2%Y/Y. Due largely to a forthcoming reset of household energy prices, inflation is unlikely to have peaked yet and this sees markets widely expecting the Bank of England to hike rates by 25bps at its February meeting to follow up its initial 15bps hike in December. Adding weight to that expectation was a tightening in the labour market, with the unemployment rate falling close to its pre-pandemic level at 4.1% for the 3-month period to November.  

Australia's unemployment rate falls to 4.2% in December

Australia's unemployment rate has fallen to its lowest since 2008 as the rebound in employment and hours worked coming out of the Delta lockdowns continued in December. While the Omicron wave is likely to see conditions weaken temporarily, Australia's labour market is tightening and forward-looking indicators point to labour demand remaining elevated in 2022. This adds weight to the case for the RBA to wind up its QE program in February. 

Labour Force Survey — December | By the numbers

• Employment increased by a net 64.8k in December in an upside result to the consensus estimate of 60k. This followed the record 366.1k rise posted in November on reopening from the Delta lockdowns. 

• Australia's unemployment rate fell from 4.6% to 4.2% (vs 4.5% expected) and is at its lowest level since August 2008. 

• Participation in the labour force remained steady in December at 66.2% having recovered to its pre-Delta level in the month prior.  

• Hours worked increased by 1% month-on-month, extending the surge in activity in November (4.5%m/m) as New South Wales and Victoria reopened from lockdowns. 

Labour Force Survey — December | The details

The incredibly robust rebound in the Australian labour market coming out of the Delta lockdowns has extended into December. Following on from the record rise posted in November (366.1k), employment advanced by a further 64.8k this month; while hours worked lifted by 1%m/m as activity continued to expand on a broadening reopening. December's output elevated employment (1.9%) and hours worked (3.0%) further above their pre-pandemic levels.  

December's 64.8k employment outcome was weighted towards the full time segment (41.5k), which contributed two-thirds of the overall increase, with part-time employment rising by 23.3k. In the month prior, it was the part-time segment that drove the rebound, consistent with the profile seen in reopenings from earlier lockdowns. 

With New South Wales and Victoria continuing to reopen, employment in those states increased by 32.3k and 24.7k to drive the national increase. Queensland contributed a 6.5k rise, but employment across the other states declined slightly. Hours worked posted a 2% rise in New South Wales and 1.4% in Victoria, but hours worked across the other states were flat in the month. Overall, employment and hours worked are running above pre-pandemic levels across all states. 

Rising employment and hours worked has led to the tightest conditions in the Australian labour market since 2008 by conventional measures. With the participation rate holding steady at 66.1%, the unemployment rate declined from 4.6% to 4.2%. Broader measures of spare capacity also fell sharply: underemployment from 7.5% to 6.6% and underutilisation from 12.1% to 10.8%. 

Mid way through 2021, Australia's participation rate was at a record high at 66.3% but collapsed to 64.5% at the depths of the Delta lockdowns. While reopenings have since seen participation rebound, it remains just off record levels. The one weak spot is in New South Wales where there is a sizeable shortfall in participation (65%) relative to its pre-Delta level (66%). In contrast, participation in Victoria—the state most heavily affected by Covid lockdowns—has rebounded to record highs. 

This shortfall in participation in New South Wales sees labour market conditions tighter there than in Victoria. Unemployment in New South Wales has fallen to 4% compared to Victoria's 4.2%. Rates of underemployment (6.3%) and underutilisation (10.2%) in New South Wales are also below the levels prevailing in Victoria (6.4% and 10.6%). A tight labour market in New South Wales could accelerate pressure on wages growth if its shortfall in participation persists in 2022, with the current Omicron wave likely to be holding back the recovery. 

Labour Force Survey — December | Insights

Going into today's report, the key focus was on the extent of labour market tightening following November's reopening rebound. With unemployment and broader measures of spare capacity coming in to be at their lowest levels since 2008, this was another very robust report. Furthermore, data on job vacancies remain very elevated, indicating that demand for labour is strong. A tight labour market together with strong demand for workers points to upward pressure on wages in 2022, particularly in New South Wales if its post-Delta shortfall in participation persists. Omicron has since complicated things and is likely to see labour market conditions weaken until the current wave passes, but this should be fairly short-lived given the underlying fundamentals. Barring any downside surprises in next week's CPI data, expect the RBA to confirm the end of its QE program at the February meeting. 

Preview: Labour Force Survey — December

Australia's December labour force survey is due to be published at 11:30am (AEDT) today. Labour market conditions rebounded very strongly as the Delta lockdowns ended, with employment and hours worked surging back above pre-pandemic levels. A recovery in participation and unemployment were indicators of a tightening labour market as job vacancies remained at very elevated levels.     

As it stands | Labour Force Survey

November saw a record month of employment as a 366.1k rebound was posted on reopening from the Delta lockdowns, coming in well above the consensus forecast for a 200k rise. This more than recovered the job losses sustained over the course of the lockdowns (-359.5k) and saw employment rising back above its pre-pandemic level for the first time since August. Employment in the part-time segment lifted by 237.8k in the month after having fallen by 251k over June-October and full-time work, which was down by 108.5k over the same period, rebounded by 128.3k.

Eased restrictions and the reopening of the retail sector and hospitality and entertainment venues drove a 4.5% surge in national hours worked in the month. The sharpest increases were seen in the states coming out of lockdown: New South Wales 5.6%, Victoria 9.7% and the ACT 10%. As a result, total hours worked across the Australian economy rebounded back above pre-pandemic levels.  

Overall, reopening effects were reflected in a tighter labour market. The participation rate rebounded by 1.4ppts to 66.1% and returned to its pre-Delta level. This occured alongside a fall in unemployment from 5.2% to 4.6%, while broader measures of spare capacity also declined: underemployment from 9.5% to 7.5% and underutilisation from 14.7% to 12.1%. 

Market expectations | Labour Force Survey

Further strength in the labour market is expected following November's reopening rebound. December employment is expected to rise by 60k on the median estimate. National unemployment is anticipated to ease by 0.1ppt to 4.5%, which is expected to be accompanied by a lift in participation to 66.2%.

  

What to watch | Labour Force Survey

With wage and inflation dynamics key to the RBA's reaction function, the focus in today's report will be the extent of any further tightening achieved in the labour market. Demand for labour is very robust, with the ABS last week reporting that there were nearly 400k job vacancies across the nation in November, while on the supply side the participation rate is just off record highs. While Omicron could disrupt the momentum, the underlying fundamentals appear very strong. Next week's Q4 CPI report will provide an update on inflation dynamics in the Australian economy.