Economic and financial market update

Problems with demand and supply

Summary:

• The Omicron wave has reduced both demand and supply in the economy;
• In the short-term this means modestly lower GDP growth. Over the longer term it is creating inflationary pressures;
• The Q4 CPI data will be an indicator as to how much global price rises are replicated in the domestic economy;
• COVID is the biggest risk to the economy. The next is rapid interest rate rises overseas to combat inflation.

Lower demand and lower supply means that the economy is not growing as fast as it could. How much COVID impacts the economy for the remainder of this year is unknown. Governments’ have shown they will tighten restrictions if they believe their health systems are coming under pressure. Consumer confidence about the health outlook will continue to play a large role on how the economy evolves. 

Barring the arrival of a far more deadly variant, the main economic issue this year will be the mix of strong demand and problems with supply. Some of the supply problems is a direct result of the current Omicron wave. These supply problems should ease over the next month. COVID has also created longer-lasting supply problems as world production has struggled to catch-up to meet very high demand. Prior to the appearance of Omicron there were signs that these supply problems were starting to be reduced. But bottlenecks were still extremely elevated by historical standards, only worsened by the latest Omicron wave. 

A bigger issue is the ongoing shortage of workers. Closed international (and state borders) is one factor, but so is the extremely high demand for employees. Monetary and fiscal policy is aimed at getting the unemployment rate lower. Worker shortages will remain an issue for this year.

Financial markets have become increasingly worried about inflation and the need for higher interest rates. Practically if inflation is towards the top end of the 2-3% target band and wages growth is rising to close to 3% that may be enough for the RBA to begin raising the cash rate. Financial market pricing is consistent with a first rate hike taking place by July. The overwhelming majority of economists expect a rate move by the end of the first half of 2023 (including me). A rising level of global rates means that if the RBA keeps the cash rate unchanged then in some respects it is easing monetary policy. 

Currently financial markets expect the peak in the cash rate to be 2-2.25%. Some in financial markets think the peak in the cash rate might be just 1-1.5% reflecting the high level of household debt. But that cash rate level might be too low if the RBA is successful in raising inflation and wages growth. Borrowers’ should be prepared for the possibility that the case rate may peak above 2.5% in this cycle. Once the RBA decides to begin to increase the cash rate it is likely to raise rates to 1% quite quickly. The pace of rate rises is likely to slow above 1% given the uncertainty as to what the peak in the cash rate will be. 

What might stop interest rates rising in Australia? Certainly the discovery of a more deadly variant would be close to the top of any list. Another is that interest rates in the US (and other countries) end up rising a lot quicker than anticipated to counter high inflation. 

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