Australian investors need to brace for higher rates after consumer prices soared past market forecasts to hit their highest level in eight years, ratcheting up pressure on the Reserve Bank to begin winding back its pandemic-era easy-money policies.
Trimmed mean inflation, which strips out the most volatile items and is the Reserve Bank’s preferred measure for policymaking, rose 2.6% year-on-year in the December quarter, two years ahead of the bank’s own forecasts and comfortably in its 2%-3% target range. It’s the highest reading since June 2014. On a quarterly basis, the index rose 1%.
Prices leapfrogged past forecasts. The RBA had banked on 2.25% in its November estimates. Westpac and Commonwealth Bank economists had forecast 2.4% and 2.5%, respectively.
Having declared in December that the conditions for a rate hike were unlikely to be met in 2022, Tuesday’s data means Governor Philip Lowe will be limbering up for a backflip, says Stephen Miller, an adviser at GSFM funds management.
“It’s a dose of reality for the RBA. Australia might be different but not that different. Prices are up everywhere, no reason to think we would be different.” he says.
“The numbers are a wake-up call. They mean there will be multiple policy rate rises in 2022 despite the Governor last year calling such rate rises highly unlikely.”
Derivatives markets are already betting on higher rates. Cash rate futures are trading on the expectation rates reach 1% by December. The first hike is expected between May and June.
The broader consumer price index (CPI) rose 3.5% for the year. Each quarter it measures almost 900,000 price changes across a basket of household goods and services. On a quarterly basis, CPI rose 1.3%.
Price increases were led by rising home construction costs and the highest petrol prices since 1990. The latter rose 6.6% in the December quarter, with the former up 4.2%.
“Shortages of building supplies and labour, combined with continued strong demand for new dwellings, contributed to price increases for newly built houses, townhouses and apartments,” says Michelle Marquardt, head of prices statistics at the Australian Bureau of Statistics.
Tuesday’s jump in prices ushers Australia towards the ranks of those developed countries grappling with the problem of inflation for the first time in a generation.
Central banks in New Zealand and the UK raised rates last year to head off higher prices. Ahead of its policy meeting this week, the US Federal Reserve is signalling as many as four rate hikes in 2022, after US consumer prices rose to their highest level in 40 years at the end of 2021.
Bye bye bond buying
Higher inflation, record low unemployment and higher rates overseas all strengthen the case to starting winding back the bank’s easy-money policies, say analysts.
“Lowe has painted himself into a corner and the exit is diagonally across the room,” says Peter Warnes, Morningstar director of equity research.
Unemployment fell to 4.2% in December, levels not seen since Howard and Rudd, and roughly a year earlier than the RBA’s central scenario forecast.
First on the chopping block is likely to be the RBA’s quantitative easing program, where it purchases $4 billion in government bonds weekly in a bid to keep borrowing costs low and lending easy.
Already slated for review, analysts expect Tuesday’s inflation data will force the RBA to announce the program’s end come its next board meeting, due 1 February.
“The RBA doesn’t need to give the market any warning because it’s already ahead of them. The market is already expecting it,” says Warnes.
Volatility for equity markets
The ASX crashed below 7,000 points following the release. At the closing bell the benchmark S&P/ASX200 was down 2.5% in a display of the volatility accompanying central banks as they begin to raise rates in a world long accustomed to easy money.
Higher rates will hit equity markets through bond yields, says David Bassanese, chief economist at fund manager BetaShares. The prospect of higher interest rates here and abroad is pushing up yields on benchmark government bonds. Higher yields lower the present value of companies’ future earnings, squeezing valuations. They also make bonds a more attractive place to stash cash.
“The reality is that as bond yields grind higher, equity valuations should grind lower. That’s what we have seen and will continue to see for a little while yet,” he says.
Yields on Australian 10-year government bonds rose to 1.94% on Tuesday, up from 1.57% a month earlier. It’s a similar story in the US where yields have risen to 1.75%, compared to the 1.49% posted a month earlier.
The rapid changes in global bond markets have already forced painful readjustments in equity markets globally. The high-flying Nasdaq Composite is down 12.5% this year as selling spreads from troubled small caps to the inner sanctum of technology mega-caps. Europe’s Stoxx 600 has shed 6.9%, while the S&P/ASX 200 is down 8.3% since the year began.
But rising inflation won’t sink all boats equally. Over the long haul, stocks tend to do all right when inflation rises, says Russel Kinnel, director manager research at Morningstar. Look for companies with strong brands who can pass price rises on to consumers, he says.
Banks and financials have historically been seen as safe inflation plays because of how higher rates pads margins.
“Households can’t avoid it”
Higher prices for essentials and the continuing impact of supply chain issues are signals inflation may stick around for longer than expected, says Warnes.
“Problem is non-discretionaries, which means essentials. It means households can’t avoid the inflation. That is the problem,” he says.
Prices for non-discretionary goods and services rose 4.5% for the year, more than double the rate for discretionary items. The category includes food, fuel, housing and health, which households struggle to consume less off even as prices rise.
Meanwhile, supply chain bottlenecks and shortages continued to make themselves felt through higher prices for goods. The rate of goods inflation rose to 4.3%, driven by jumps in furniture, motor vehicles and clothing accessories, up between 5.7% and 6.8%. In contrast, services rose 2.3%.
“More broadly, global supply chain disruptions and material shortages, combined with rising freight costs and high demand, contributed to price increases across a wide range of goods including dwelling construction materials, motor vehicles, furniture and audio-visual equipment,” says Marquardt.
An end to restrictions in many states and border reopenings ahead of Christmas led to a big jump in prices for domestic travel and accommodation, up 4.8%.
“A lot of these supply chain issues are going to be hanging around for a little while. Yes, the rate of growth will slow, but there’s a lot of pandemic-related costs embedded into many companies and that will keep prices up,” says Warnes.