Transcript of Question & Answer Session Recent Trends in Inflation

Thank you, Phil for such a topical and engaging speech as always; it's well-timed. A bit earlier people have had questions … from the audience, so please if you're in the room and you'd like to ask a question, put your hand up. We've got one already. And on the virtual audience, I know there's some coming through already. But if I'm looking at my phone it's not because I've lost interest, it's because I'm curating the questions online. But to get things started, why don't we start? I think Rory, you actually were first, so we'll go with Rory. And if you can state your name and affiliation, while you're asking your question, too, please. Just for the benefit of the virtual audience, the question is about market pricing versus Governor Lowe's comments.

There may be people in this room who are better equipped to answer that question. All I can tell you is how I see the world and I see the world as having only a gradual increase in wages and only a gradual increase in inflation and given our policy framework that would not justify an increase in interest rates next year. So why might the market be expecting rates to go up next year? I think at least conceptually, there are two possibilities. One is they think we have a different reaction function. I sometimes read that we're going to increase interest rates to stamp out the rises in house prices. I've said a number of times, we're not going to do that. So that's not in our current reaction function. So if you think that's why we're going to raise interest rates next year, well, I'd encourage you to rethink.

The other possibility is that you think that inflation is going to pick up much more quickly and you think that our condition for meeting the cash rate will be met next year. we can't rule that out – I can't say that has a zero probability. But I think it has a very low probability because it would require wages growth to pick up very substantially and probably above 3 per cent. It's quite a few years ago, that wages growth, the aggregate level was above 3 per cent, in Australia during the resources boom. So the probability of us unwinding that decade long decline in wages growth in just six months, seems very, very low to me. It probably isn't a zero, but it's close to zero. There may be other people in the room who can provide a fuller explanation.

We'll go to another question on the floor. I think Jonno, you were actually next and it's your venue, so you get to go next. Just name and affiliation. So again, the question for the virtual audience is about spare capacity in the labour market and potential wages pressures building up.

Yes, so compare the situation with the United States where participation is still low, so it's quite possible as demand for services picks up there, which it is at the moment, that people are drawn back into the labour market, and some of the pressures we're seeing on wages in the US start to dissipate. So that's entirely possible because there are a lot of people still to come back into the labour market. In Australia, we don't have the same release valve, but there are two other potential release valves. One is underemployment. There are 30-35 per cent of Australians who work part time and a lot of those want to work extra hours. It may well be in the next six months they'll get the chance to do that. So there's extra labour hours that could be supplied to the market. And the other thing that's quite important is the opening of international borders. If you talk to any of the hospitality providers in Sydney or Melbourne at the moment, they're saying that it's hard to get workers. They still rely on students and people here on short-term visas. They're having trouble getting those. And it's quite possible over the next six months, the borders open and we get more labour supply from that source as well. But developments in labour supply are a first order issue at the moment, and again, it will really reshape wage outcomes in many of our countries and you're seeing the effect of that right now in the US and the UK.

We'll go to a virtual question and then we'll come back to the room. It's from Ivan Colhoun at NAB. And thanks for your address, Governor, he is interested in how you might respond to the situation where core inflation was temporarily or transitory higher at 3 per cent, but wages have only accelerated, to say 2.5 to 2.75 per cent. How would you deal with that situation; that it wasn't accompanied by wage inflation?

Well, I mean, it's hypothetical, but in principle, well you could have that configuration. It would be quite worrying if productivity growth stopped and well, let's say it's negative then you could have wage growth of 2 point something and inflation at 3. It would be a very bad configuration. It's not something that monetary policy could do anything about, but it's conceptually possible, though I think quite unlikely. The other possibility is that there are some short-term dynamics in goods prices, or even some sense of rising inflation that push measures of underlying inflation up. If that's all it is and wages aren't adjusting, I think once again, we're prepared to look through that. Because if wages are only growing at 2.5 per cent, I don't think we're going to have any inflation problem in this country. So if underlying inflation was 3, well it would obviously be something that's kind of short term and probably likely to reverse. So it's hypothetical, but in principle, we would be prepared to look through that.

So the question is about the peak in the cash rate, not the timing of first move and what the neutral rate may be.

It's a good question, but it's also a very hard question. Well, let's hope the answer is at least 2.5 per cent, because that's what we want to deliver you on inflation on average. So a 2.5 per cent cash rate would be zero real. I'm hopeful that we can do better than that and the economy should be able to generate at least 1 per cent labour productivity growth, I hope. All else constant that suggests a positive real interest rate and perhaps 3.5 to 4. But I mean, we're really in the hands of what happens internationally here, because the story for the past two decades, a decade and a half, has been very elevated appetite to save globally and depressed appetite to invest. When everyone wants to save and no one wants to use your savings to build new firms, you get a low return on your saving. That's the world we've been in. That's really why we've had low interest rates up until the pandemic.

What does the next five years hold? Are we going to see people who've actually had their balance sheets improved a lot because of all the supplemental income from governments? Are they going to spend that and the saving rate comes down and are firms going to refine their mojo and start investing again? They're big questions, but let's hope the number's higher than 2.5 per cent.

So the question is about not just supply issues driving up inflation, but potentially the fiscal policy response to COVID and what would happen to inflation, given the income in the economy that's sloshing around. What would happen to that as the fiscal response starts winding down post COVID?

That's a very good question as well. I think the fiscal income support that people got was very important in allowing them to buy all those goods. If our incomes had fallen as much as we thought could have been possible we wouldn't have been able to buy all that home exercise equipment and the home office and do all that online shopping. So in keeping the aggregate level of consumption high, fiscal policy was incredibly important. It didn't drive the big switch in spending patterns that I've talked about, but it allowed aggregate spending to stay high. Here, and in many countries around the world, people saved a lot of that income and household saving here has been very, very high. I know when I meet with my colleagues from other central banks, they talk about the same dynamic and I think it's quite plausible now that with vaccination rates being very high people have confidence in the future, we see plenty of jobs and wages rising. So my expectation is that people will be prepared to save a bit less going forward, and they'll be prepared to draw on the accumulated saving. Critical to that assessment is the idea that people are going to be confident about the future. If we saw further setbacks on the health front, it's likely we go back into our shells and not want to spend again. But if the health news is reasonable, people are getting jobs, their wages rising, I think they'll spend.

Governor, we'll go back online and then we'll come back into the room. It's from Mark McCarthy at AFMA. Do you think the monthly releases of Australian CPI data would give the RBA a better opportunity to respond to inflation and why doesn't the government fund the ABS to provide more timely data?

You would have to ask the government that. In my business, more information is better than less so I'd welcome monthly CPI, but that's a matter for the ABS and the government. Would it make a fundamental difference to monetary policy? I'd suspect not, there are particular points or points in time where it might be really informative, but most of the time, our judgment, our decisions are based on medium-term considerations, not on the latest reading of one particular series. And with the improvements in the availability of data and our data capabilities, we have a better indication of the trends in price on a month-to-month basis than we used to as well. Of course, I'd like to have it because I always want more, but I don't think it would make a fundamental difference in any case and that's probably why the government doesn't want to fund it.

I will go online again and then we'll come back into the room. This is from Nick Gusnan, the trajectory for inflation is also important with a slow drift up in underlying inflation, having different policy implications to a sharp rise. How fast and high is a sharp rise in inflation and what is the implication for the RBA achieving sustainable inflation?

It's very hard to be specific there about how sharp and how fast. Perhaps I can talk in broad terms. If the inflation dynamics were changing very, very quickly and underlying inflation was rising and wage growth was picking up and things were getting hot very quickly, we would be prepared to respond to that. But if it's more kind of a slow grind where things are gradually getting a bit warmer and price and wage pressures are increasing, I think we'd have more time. So, you know, we're in the world of hypotheticals, so I don't really want to speculate. But if inflation pressures and wage pressures were picking up very, very sharply, we'd have to respond more quickly than we would if things were building slowly over time. I can't kind of put more specificity around that than that.

That's all right. Thank you, Governor. Let's come back maybe into the real world in the room, hopefully and go to Su-Lin. So the question is about the announcement this morning in the minutes about the review of the yield curve control policy and Su-Lin is asking whether there'll be a broader review of other policies.

Our intention is hopefully next year, the economy has recovered from the pandemic and the unemployment rate is tracking down, the economy is growing at 5 per cent.It would be appropriate once we're through to the other side that we step back and look at the whole experience. We implemented incredibly innovative policies, things that I never thought we would do – yield target, buying a huge number of government bonds, a term funding facility to the banking system. So it's appropriate, I think, once we get to the other side next year, that we step back and review that and our intention would be to make that public, in the form that is useful to the community. So really just looking back, I mean, it's an appropriate thing to do and we'll do that. It's different from the other reviews about the Reserve Bank that are floating around in the media, but we thought it's appropriate for us to look at the package of measures. Were they effective? What are the lessons for next time?

So the question is about QE and the calibration of QE and whether you'll be changing that calibration based on actual inflation or forecasted inflation. And now that you are back in the target range, I think I'm paraphrasing Tapas, is there a need to continue with QE for longer?

On that last question, we'll decide that in February and how we continue with it. But right from the outset, we've said our decision-making framework was based on three factors. The first, what other central banks are doing. To some extent, we entered into the world of QE because that's what other central banks are doing. If we weren't doing it as well, the exchange rate and interest rates would have been higher, and that would have been unhelpful for getting to the other side of the pandemic. So what other central banks are doing is incredibly important. The second consideration was how our bond market was functioning. Some bond lines, we own 40 per cent, some bond lines, 50 per cent. So we need to pay attention to how the bond market is working. And the third consideration and the most important one is both the actual and forecast progress towards our goals of full employment and inflation targets. So in answer to your first part of the question, the forecasts are quite important in shaping decisions about the bond purchase program and when the board meets again in February, we'll have a new set of forecasts and they'll be as important as the actual outcomes in determining what we do next. And whether we need to keep continuing with it will depend upon what those forecasts say and what progress we make between now and February.

We'll go online for a couple of questions. Governor, this is from Becky Davidson. Is the Reserve Bank incorporating the global emissions reduction agenda and potential reduction of fossil fuel usage in the real economy, into its assessment of productivity and its impact on other economic indicators, including inflation?

We will over time but our forecasting horizon at the moment is two years. So while these are important considerations and they're not having a major bearing on the outlook for the economy over the next two years, but I predict that over the next 10 or 20 years they'll be major factors shaping our economy and we'll have to incorporate those into the outlook.

I've got a question here from John Kehoe of The Financial Review. The minutes today flagged a review - oh, we've already asked that question. Thank you.

Two big questions. So the first one was really what is going to be the impact of the opening of the borders? I think that it's hard to tell because one of the things that will happen when the borders open is Australians who want to work overseas will also go overseas. There are many young people who haven't had the opportunity to do that in the last two years and I expect that we'll see kind of a lot of people wanting to go and work overseas again. So that will be a reduction in labour supply. It will though, I think be a bigger flow in the other direction, and the effect of that on the labour market will depend upon the skills that those people bring.

Most of us here work in financial or business services and we all know at the moment, it's very hard to hire people with project management skills, cybersecurity and compliance. So one imagines when the borders open, those skills will be able to come into the country and the other thing that we'll see is the students return and the backpackers return, which will also help the hospitality sector. So with those things, if labour supply is increased, then that will take some of the pressure off the hotspots in the labour market at the moment. It's really hard to tell what effect it has on aggregate wage outcomes but I think for some of the hotspots, the pressure will come out of those when the cyber professionals can come back in, and the project management people and the skilled waiters. But remember, Australians rightly will go overseas as well. So you've got to look at the whole picture.

On household debt, I would be worried if household debt continues to grow at say double-digit rates and income's growing at 4 or 5. Households in Australia already have high levels of debt relative to our income. I think we're building up medium-term risks if we are in a world where household debt is persistently increasing at 10 per cent a year and incomes are growing at 4 or 5. I think that's problematic. And so the Reserve Bank work with APRA on increasing the loan serviceability buffer which we strongly welcome, and it may be in time that more needs to be done. We don't know yet, but more may need to be done there. What the Reserve Bank is trying to do at the moment is try to get us back to full employment, inflation back to roughly 2.5 per cent and interest rates normalised. So we're trying to get interest rates up over time. We're in no hurry, we're patient, but if we're successful, interest rates will go up and people who are borrowing today need to remember that. So there's a balance to be struck here. I think we don't want to see credit growth being at really elevated levels for a long period of time.

Governor, I'll ask another question from online, because I think it's a student and it's Lisa Maher, an economics student from Killarney Heights. And Lisa is asking do you have any thoughts on the role of the Fair Work minimum wage decision, enterprise agreement, negotiations and public sector wages caps on reducing wage growth expectations?

All those three things impart inertia into the system. We have an annual review of the minimum wage, and the Award wages and many enterprise agreements of three years or two or three years. And the public sector wage policies tend to move very slowly. So you put those three things together and they impart quite a lot of inertia into aggregate wage outcomes. So the wages in parts of the private sector can be rising quickly because skills are in short supply. But there's other things again to impart inertia. This is one of the reasons why we think wage growth will pick up only slowly. If we didn't have those processes, then I think we could see wage growth pick up more quickly in response to the tight labour market. But we do have those three things and they're all quite important.

We'll go right down the back.

I most certainly don't have that confidence.

Governor, I'll just paraphrase that question. It was a long question, but I think you were asked why you were so pessimistic or why you're so dovish relative to the rest of the country, which I think is overstating things, but I'll let you answer.

Yeah, I wouldn't characterise it quite like that. I'm expecting the unemployment rate to get to 4 per cent in two years' time, I'm expecting the economy to grow by 5 per cent next year and 2.5 per cent the following year. I'm expecting inflation to be in the 2s. That's a very good set of economic outcomes and I remain incredibly optimistic about the medium-term prospects for this country. We've got fantastic natural resources. We have the capacity to capitalise on the energy transition, a talented and skilled workforce, a dynamic innovative population. So I'm still very optimistic about the future of the country, but I do recognise that price pressures are quite weak. To talk about kind of being dovish and negative. That is really a kind of realism about the price pressures in the country and we're going to keep interest rates where they are until we're very confident that inflation is going to kind of be around 2.5 per cent and stay there and we get back to full employment. So my characterisation is different. We're really back to the question Rory asked at the beginning, why is my view about the likely trajectory of interest rates different from what's priced into the market? I think it's either the reaction function which [inaudible] that or it's the outlook for wages. If you think wages are going to go from 2 per cent to 3.5 or something in six months, well maybe the market's right and we're wrong.

Governor, I'll ask this question from online. It's an anonymous attendee, which troubles me, but I think it's a student so we'll press ahead and it's relevant to what you just said. Is the Reserve Bank thinking there might be a different way to construct your forecast using your expected path of the cash rate rather than market pricing given there's such a big difference between what the Reserve Bank has been communicating, including yourself, and what's priced into markets.

That's a technical question really about how we construct our forecasts. Our approach for many years has been to use the market path, which at the moment as we've been talking about is upward sloping. We've incorporated that market path into the latest set of forecasts. If we'd included a flat interest rate forecast path the numbers for 2022 wouldn't have been any different because remember there are lags between when we change interest rates and economic activity and the Phillips Curve is quite flat. So even when you change economic activity, it takes a while for that to feed through inflation. So the main impact of using a different interest rate assumption would be in the economic outcomes forecast for 2024 and ‘25, and our published forecasts don't go out that far. So, for the next two years, it doesn't really make that much difference. And we've done that exercise internally and it makes a difference at the end of the forecast horizon, because once you take into account the lags and the fact that it still takes time.

Thanks Governor, we've got time for maybe one or two. So Adam down the back. So the question is about the functioning of the bond market, particularly in recent weeks with the bank ceasing the targeting of the particular bond.

There's no doubt the market had a couple of difficult weeks. I think it started with some data in the US and a reassessment of the global inflation outlook. And then bond yields went up in Australia, including the yield on the April ‘24 bond and we waited for a few days to see how things settled. They settled at too high a rate above the 10 basis points and we intervened once in the market. Then a couple of days later, we had the Australian CPI, which was stronger than we expected, and we decided to sit out of the market for a few days because the Board meeting was only a few days later and during those days, things were turbulent. Bid-ask spreads were wide, trading was difficult. Since then, things have settled down. Most bid-ask spreads have come back in again, still a bit wider than they were before, and my understanding is from the domestic dealing staff at the Bank that conditions in the market are stabilising at higher yields. It's understandable, people are still trying to work out what the direction of interest rates here and elsewhere is. And so I don't know if you've got a kind of different perspective.

It's a follow up question about liquidity and being quite thin in the market and how the Reserve Bank might respond in February.

So if liquidity conditions are difficult, I think the question we'd be looking at is, is that because we hold very significant shares of each line? Or is it because people are genuinely trying to work out what the future path of interest rates is. There's quite a lot of uncertainty around that at the moment as the questioning in this room has highlighted. I suspect, well, it's a combination of both, but probably more the latter. People are trying to work out what the future path of interest rates is here and when that uncertainty is there, people are a bit more reluctant to trade at fine spreads. I think that's probably the main issue, but our bond holdings could be playing into that and we'll be looking at that ahead of our February meeting.