From Gareth Aird, head of the Australian economy at the CBA:
- The war in Ukraine adds a significant layer of uncertainty to the global economic outlook, particularly in Europe.
- Intraday volatility is likely to be significantly higher in short-term financial markets.
- However, the impact of Russia’s invasion of Ukraine on the Australian economy is expected to be minimal.
- Rising energy prices will boost export earnings and national income, while an expected rise in oil prices means higher gasoline prices and additional upward pressure on headline inflation .
- Measured consumer confidence can also be negatively affected by rising oil prices, increased stock market volatility and general apprehension, which is a natural response to war. But we don’t expect this to change consumer behavior.
- The overall picture of strong domestic demand in 2022 remains unchanged and we remain bullish on Australia’s economic outlook.
- We have made no changes to our central scenario for GDP, unemployment, wages or core inflation (the headline inflation forecast in the near term has been raised slightly).
- Our base case scenario remains that the RBA will start normalizing the cash rate in June after concluding that “inflation is sustainably within the target range” at the board meeting.
The bigger picture
Russia’s invasion of Ukraine adds a significant layer of uncertainty to the global economic outlook, particularly in Europe. The wide range of potential geopolitical, economic and financial implications of the war rattled financial markets. Commodity prices in particular have been incredibly volatile over the past week given that Russia is a major supplier of thermal energy (oil, gas and coal).
Russia’s invasion of Ukraine comes at a time when inflation is high in many Western countries, complicating the path to policy normalization for some central banks. This increases the likelihood of significant intraday volatility in financial markets over the coming period. In other words, the markets will have a lot to do.
However, it is important to distinguish between financial market volatility and the real economy. Australia’s trade relations with Russia and Ukraine are negligible. And we expect Australia’s economy to be largely insulated from war provided major military powers in Europe and the United States do not fight Russia in Ukraine or elsewhere (this is our base case).
We say largely isolated because there will be repercussions from the invasion on the Australian economy. These are not large enough for us to make any changes to our central scenario for GDP, unemployment, wages or core inflation, which means we maintain our call for the RBA to begins to normalize the cash rate in June. But they deserve discussion.
Oil prices were rising steadily before the invasion
Prior to Russia’s invasion of Ukraine, oil prices rose steadily in Australia due to rising world oil prices. For context, tanker prices were up around 15% in the six months to mid-February due to rising global demand and some supply issues. Rising gasoline prices contributed 0.3ppt to the quarterly rise in headline inflation in Q3-21 and 0.2ppt in Q4-21.
Automotive fuel (ie gasoline) accounts for approximately 3¼% of consumer spending. But the share of gasoline expenditure for each individual household varies considerably. Low-income households on average spend a much larger share of their budget on gasoline than high-income households. A rise in gasoline prices therefore has a disproportionate negative impact on households with the lowest incomes.
Gasoline has trended downward over time as a share of total consumer spending. Nevertheless, it is still a significant part of many households’ expenditures and large increases in the price of gasoline are a de facto tax on households.
Over the past six months, there is no indication that rising gas prices have weighed on total household spending. Overall spending rose sharply alongside the general improvement in the economy and labor market. A strong increase in household incomes due to government transfers, tax cuts and an acceleration in wage growth has enabled households to better cope with rising gasoline prices.
Oil prices will rise further
Russia is responsible for around 10% of the world’s oil production. Russia’s invasion of Ukraine and potential sanctions on Russian exports mean further increases in the price of oil and, by extension, gasoline prices are likely over the next few months.
Our hard commodities strategist Vivek Dhar expects Brent oil to average ~US$110/barrel over the next six months (the price spike could be much higher than that). On an unchanged AUD/USD, a six-month average Brent price of US$110/bbl would lead to average domestic gasoline prices of around A$1.95/l. This would add an additional 0.5 ppt to headline inflation over the period and we have adjusted our forecast profile upwards accordingly (we now expect headline inflation to reach 4.4%/y by mid-2022) .
However, we have not made any changes to our core inflation forecast profile (we expect core inflation to reach 3¾% by mid-2022 and remain there broadly in H2-22 ). Rising oil prices due to Russia’s invasion of Ukraine could cause prices to rise further for other goods and services for which oil is an input to production. But our central scenario for core inflation already incorporates higher input costs and higher product prices due to steadily rising oil prices before the war. Thus, at this stage, we view Russia’s invasion of Ukraine as an upside risk to our core inflation scenario.
We have not adjusted our profile for actual household spending or the unemployment rate. Some marginal households will reduce their discretionary spending due to a further rise in gas prices. However, we do not expect this to be significant enough to warrant a change in our assessment of the path of consumer spending in 2022. By extension, our forecast for the labor market remains unchanged.
The level of household savings accumulated during the pandemic is extraordinary (~12% of GDP) and this will provide a tailwind on spending over the next two years. The overview remains intact.
Higher energy prices mean a bigger trade surplus and stronger nominal GDP growth
Higher oil prices will translate into higher gas prices, which will benefit Australian gas producers. LNG is Australia’s second largest export and in 2016 Australia became a net fuel exporter. This means that a rise in oil and gas prices boosts the trade balance, the terms of trade and nominal GDP, all other things being equal.
The impact of increased export earnings on the economy as a whole, however, is less direct than the impact of higher oil prices on consumers. It takes time for profits to flow to shareholders and there is a high level of foreign ownership in the Australian LNG sector.
Nevertheless, domestic shareholders of Australian gas exporters will benefit from higher energy prices. And the budget result is also improving thanks to higher export prices through corporate taxes and the royalty channel.
Our RBA call is unchanged
The RBA will begin to normalize the cash rate when the Board concludes that “inflation is sustainably within the target range.”
Based on our expectation that Europe and the United States will not fight Russia in Ukraine, we maintain our call that the first increase in the cash rate will take place in June 2022. This risk is biased towards a later date for take-off, August being the most likely next month.
We expect a very hot CPI in Q1 22 which will bring the underlying inflation rate to ~3.4% (4.5% on a six-month annualized basis). We believe that a print of core inflation in line with our forecast means that the RBA will not need another CPI report to conclude that inflation is “sustainably within the target range”. The RBA will simply need to be satisfied that wage growth is approaching desired levels and the economy is at full employment.
Earnings data released last week indicated that wage pressures were building towards the end of 2021. The 0.7% rise in the Wage Price Index (WPI) from Q4 21 was the WPI’s largest quarterly increase since March 2014. And according to the ABS, “the proportion of wage increases reported in the December quarter was higher than typically seen.”
The WPI including bonuses recovered markedly in Q4-21 and the annual rate rose to 2.8%. Average weekly total earnings rose sharply by 3.8% year-on-year in November 2021.
The WPI for Q1 22, due May 18, should show a further, more significant acceleration in wage growth. The unemployment rate stood at 4.2% on both December 21 and January 22, which is significantly lower than the average unemployment rate of 4.7% over the three months preceding November 21. the risk is linked to a stronger result.
Inflation data in line with our forecasts along with a strong WPI in Q1 22 and an unemployment rate that is expected to be in the smattering of 3s should be sufficient evidence for the RBA to conclude that “inflation is sustainably in the target range” at the June Board meeting. As such, it will be appropriate to begin a cycle of tightening.
In summary, we believe that the impact of Russia’s invasion of Ukraine on the Australian economy is likely to be minimal. Thus, we leave our forecasts unchanged for GDP, unemployment and wages. And we keep our RBA appeal.