Inflation and wages could return to the target range quicker than the RBA thinks

The biggest question in local and global financial markets is no longer about the COVID pandemic. It’s about inflation and whether it will stick around.

• The current bout of inflation is more than transitory.
• RBA models have a bias toward low price rises.
• Mortgage rates likely to start drifting higher

CENTRAL BANKS around the world acknowledge that the global economy is in the midst of a bout of inflation. Most argue it’s transitory, driven by supply-side effects that will dissipate later in 2021.

But has the Reserve Bank of Australia, and its peers, got it wrong?

Quite possibly, says Tim Hext, portfolio manager in Pendal’s Bond, Income and Defensive Strategies team.

“We think that inflation and wages will come back to the RBA target range a lot quicker than the Reserve Bank thinks.”

One of the reasons for the central bank’s potential misreading of the economy is because it forecasts inflation using a model developed about five years ago, which picks up on inflation expectations, Hext says. And expectations over recent years have been low.

“So the model says … the best guide to future inflation is past inflation, because of people’s expectations. It says businesses will be slow to increase prices and consumers won’t be expecting inflation to be a problem. It has a bias in it.”

Another reason for the likelihood of the official cash rate rising sooner than the RBA’s current forecast of 2024 is because it came out so publicly about rates remaining low in an effort to stem the downturn in the economy.

“The Reserve Bank is like a big oil tanker. It takes time to turn around,” Hext says.  “After providing strong guidance last year, everything in the economy started improving.

“It’s gotten to the point where they’re now using inflation to fit their narrative, as opposed to building their narrative around inflation.”

“It suits them to use the inflation figures [which are very low], but you have to remember that inflation lags the economy by 12 to 18 months. The economy started to pick up in the middle of last year, so I expect to see inflation at the end of this year,” Hext says.

He doesn’t support the view that the supply-induced price rises, currently apparent in the economy, are transitory.

“You’re going to see goods prices squeezed and businesses are in a pretty good position to pass on the cost increases. The data is already showing that in the US.

“And services inflation, which is more important than goods inflation, is exposed to labour markets. Labour is the primary input into services. And the labour market is going to get a lot stronger. It’s likely to be near four per cent this time next year.”

The oil tanker, as Hext puts it, will have to start turning.

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The first thing the Reserve Bank did was switch off the term funding facility for banks at the end of June, thereby denying lenders a cheap source of funds, Hext says. 

They have also announced a taper of quantitative easing by reducing purchases of government bonds from $5 billion a week to $4 billion a week in September, although recent lockdowns may see that timing pushed back.

And finally the central bank will have to lift the official cash rate, which is used to price other lending rates.

Hext says the term funding facility played as big a role on interest rates for mortgages on the way down and is likely to do so on the way back up.

“The money the banks borrow [to lend to customers] will be at a higher rate once the funding facility ends. It will take time to work through the system, but the overall cost of funding for banks will go up. And mortgage rates will start drifting higher.”

The spectre of inflation is back, and as Hext puts it, the Reserve Bank oil tanker might need to turn just a bit faster.