Market pricing, lift-off conditions, and MARTIN

The Australian short end has recently re-priced in sympathy with global rates markets. While this has been in direct defiance of Gov Lowe’s observations on OIS market pricing (Lowe said pricing was “difficult to reconcile” with the outlook 14 Sep Anika speech), it’s also within the bounds of normal. A sell off with other markets is common, as is a sell off after the final easing. Once the RBA’s Delta-decision had been made, it was clear that peak-easing for monetary policy had occurred. What’s not clear is if hikes have come into focus. If inflation remains low, there will be big opportunity to fade the hikes in the AUD short end.

The trade might have to await the re-opening surge. The data will surely accelerate as the economy re-opens and it’s tricky being received into accelerating data. It is especially hard if you don’t trust the central bank — and I think a lack of trust is a big part of the problem in AUD rates just now.

However, there’s a price for everything. A low Q3’21 trimmed mean CPI print should push the hikes back.

Market Pricing = basically to rule

The RBA is sometimes characterized as unpredictable. On a meeting-by-meeting basis this may be true (see 2019), however over the last decade they have hewed pretty closely to the monetary policy rule published in MARTIN (their econometric model, see here for all the model equations). Using the RBA’s August SOMP forecasts, current market pricing is basically in line with the MARTIN cash rate rule. This suggests that no weight is being placed on the RBA’s new forward guidance.

The Policy rule spelled out in MARTIN says that today’s cash rate is much the same as yesterday’s cash rate (0.7 * prior cash rate) with changes due to moves in RSTAR (which is estimated following this note), inflation (the difference between trimmed mean inflation and their 2.5% target), and the unemployment rate. The unemployment rate enters twice: once in terms of the gap between the unemployment rate (LUR) and full employment (TLUR, estimated following this note), and a second time as a speed of adjustment term (the two quarter change of the unemployment rate). In what follows, I’m using 4% for the NAIRU and -0.25% for RSTAR.

The forecast cash rate from this model lines up pretty well with the actual cash rate for the post GFC period (as you’d hope, given that the model was published in 2019). The RBA does appear to lag in the COVID-crash, but that’s mostly about publication lags (the RBA can’t react to lower inflation and a higher unemployment rate until they see it).

The sharp move down in H1’20, and the recent pricing for hikes, mostly reflects the speed of the unemployment rate’s moves (the rapid move up and then down of the unemployment rate). This is mostly noise in the current period, as participation rate changes due to lockdowns have messed with the unemployment rate. Moreover, the RBA has told us to ignore this term.

The 2020 introduction of the sentence “The Board views addressing the high rate of unemployment as an important national priority” means that the RBA isn’t putting any weight on the speed-of-adjustment term just now. They want the unemployment rate to fall, and they won’t be increasing the cash rate because the unemployment rate does what they want it to do.

If we remove the speed of adjustment term from the rule, you get the chart below (the rule that is focused on the unemployment gap is lightblue). With this adjustment, the move down in 2020 isn’t so aggressive, and the hiking profile is more modest — because the RBA reacts to the size of the output gap, rather than the pace of change. It takes time to get the unemployment rate down to ~4%, so the hikes come later. I’m using the August SOMP numbers here, so I’ve got the unemployment rate settling at 4% in H1’24.

Lift-off conditions

Gov Lowe attempted to push back on (much more modest) market pricing in his Anika Speech, on 14 September. He noted the change of target, to actual inflation; and that the RBA wanted to see inflation around the middle of the target range and have reasonable confidence that inflation will not fall below the 2-3 per cent band again before lifting off. These changes should lower short end pricing relative to the MARTIN rule (though they may boost rates later, if inflation overshoots).

As I have discussed on previous occasions, last year we moved to an approach under which actual inflation, rather than forecast inflation, plays the more central role in our cash rate decisions. In today’s low inflation world we do not want to run the risk that we increase the cash rate on the basis of a forecast that ultimately does not come to pass, leaving inflation stuck below the target band. We want to see actual results, not forecasted results, before we lift the cash rate. Once we do see these results, forecasts of inflation will again have a role to play. But we have to get there first.

In particular, the Board has said that it will not increase the cash rate until actual inflation is sustainably within the 2–3 per cent target range. It won’t be enough for inflation to just sneak across the 2 per cent line for a quarter or two. We want to see inflation around the middle of the target range and have reasonable confidence that inflation will not fall below the 2–3 per cent band again. Our judgement is that this condition for a lift in the cash rate will not be met before 2024.

RBA Gov Lowe, Delta, the Economy and Monetary Policy, 14 Sep 2021 (my emphasis)

So we now have three changes to the MARTIN rule. 1/ no speed of adjustment term; 2/ the cash rate remains at the current level until we’ve had two trimmed mean prints around 2.5%yoy, and 3/ the RBA must be confident that inflation will remain in the target range. The third element is poorly defined, but I think sustainable inflation means these mid-target trimmed mean inflation prints come with wage (WPI) prints that are around, or a bit above, 3%yoy.

The OIS market has lift-off priced for Q3’22 — Is that plausible?

There are two available interpretations of market pricing: either the market expects high inflation, or it doesn’t believe the RBA’s forward guidance. Let’s assume the market expects higher inflation for now.

If the RBA sticks to the rules they have described for lift-off, a hike in August 2022 requires inflation of a little more than 0.6%qoq for each of the next four quarters. An acceleration from 0.4%qoq to 0.6%qoq isn’t impossible, though it’s been many years since we had such an outcome.

The OIS market is pricing inflation like it’s 2014!

While it’s possible that a series of supply-side issues might deliver trimmed mean inflation of ~0.6%qoq per quarter over the next year, it’s much harder to imagine wages growth of 3%yoy. That is important, as fast wages growth will ultimately give the RBA confidence that inflation is going to remain inside the target band. For institutional reasons, the wage process in Australia is quite slow moving. This is why Gov Lowe found it so hard to reconcile market pricing with his outlook for the economy in his September Delta speech.

If we had trimmed mean CPI above 2.5%yoy and wages above 3%yoy, it would justify OIS pricing that’s ~50bps higher than current market pricing in the 2023 to 2026 sector of the curve (the terminal rate is about 2.25 % given RSTAR at -25bps). Here I’ve assumed that inflation returns to 2.5%yoy in Q2’22 (allowing lift-off min August 2022) and remains there. In reality, inflation would probably overshoot, so the RBA might get the cash rate above 2.25% for a time.

The problem with the inflation story is that OIS forwards don’t reach 2.25% until the 2030s (I judge neutral to be 2.25% = the RBA’s 2.5% target less R* of -0.25%). One interpretation of this is that the market is pricing in an error — inflation that’s temporarily high enough for an early lift-off, but isn’t sustained, so that the RBA doesn’t get the nominal cash rate back to neutral until 2030. Another is that the market’s RSTAR is below -0.25%, so neutral is lower than 2.25%; but I think -0.25% is to the low side of the fair value range. The final interpretation is that the RBA has a credibility problem.

I think it’s the latter: market does not value the RBA’s forward guidance.

What can the RBA do?

There’s an easy enough fix to this. Gov Lowe should simplify the monetary policy message. His use of imprecise language when talking about the normalisation conditions is unhelpful.

He should simply say that the RBA will not lift the target cash rate until the two quarter average of trimmed mean CPI is over 2.5% (on a year ended basis). He took a step in this direction in the Anika speech, where he said that they wanted inflation “around the middle of the target range”. Making this more precise would help the market.

Clearing up the YCC exit strategy would also be helpful. A clear statement that the RBA would simply move the YCC bond rate with the target cash rate, in the case that they hike prior to the maturity of these bonds, would help tremendously.

Conclusion

Market pricing of the RBA’s policy rate is pretty much in line with the monetary policy rule published in MARTIN. The problem with this is that the RBA’s forward guidance tells us pricing should be below the old rule. It not simply a question of the market having a higher inflation forecast. The market doesn’t appear to have put any weight on the RBA’s forward guidance.

Market pricing implies lift-off in Q3’22. To achieve this without breaking the RBA’s recent commitments would require a string of 0.6%qoq (or higher) results for trimmed mean CPI, and a material acceleration of wages. That’s plausible, though unlikely.

If the market believed high inflation was coming, it should price a steeper path between lift-off (Q3’22) and the terminal rate of 2.25%. After all, the RBA is starting late in the game (because they are waiting for realised inflation) so tightening to neutral ought to be surer and a bit faster.

Assuming we get a Q3’21 trimmed mean inflation print that’s ~0.5%qoq for Q3 (1.8%yoy) the RBA is likely to push back on market market pricing using both the November SOMP and Gov Lowe’s 16 November Speech. The RBA uses market pricing for the cash rate in the SOMP forecasts, so comparing the Nov SOMP inflation forecast to the RBA’s 2.5% target will make it clear if the market has got it wrong.

The RBA could make a big contribution to solving this problem by making a crisp and clear statement about lift-off conditions. Making it clear that the YCC rate will move with the cash rate in the case of an early lift-off would also be helpful.

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