Financial markets are starting to look towards the end of central bank rate hikes as well as towards “soft” economic landings for the world’s major economies. Soft landing prospects have been boosted by mostly decelerating annual inflation so far in 2023 improving the likelihood that rate hikes are near an end. Also favouring soft landings, household spending and labour markets have held up reasonably well so far in response to aggressive monetary tightening over the past year and more.
The US economy appears to have held up particularly well, but even the European economy seems to be just staying out of recession. The Australian economy is also a possible candidate for a soft landing, but the prospect is more finely balanced than for the US or Europe.
The resilience of household spending and labour markets in the wake of substantial rate hikes is a mixed blessing for central banks. It means that their policy actions have not triggered recessions so far, but it also means that decelerating inflation may not go far enough, that annual inflation bases too high over the next year or two. Even though financial markets see rate hikes close to finished, central banks may still take a different view.
It is worth noting that most major central banks, including the US Federal Reserve, the European Central Bank, the Bank of England and our own RBA, while all indicating that the worst of the monetary tightening cycle is over are also all leaving the door open to further rate hikes if the data relating to demand, the labour market and inflation require. Also, they are all indicating that they see little opportunity to start reducing interest rates in the near-to-medium term, a message that financial markets are choosing to ignore for the time being.
Returning to the likelihood of a soft landing the prospect in Australia seems more precarious than elsewhere. Australian households have been more responsive to higher interest rates than US households even though the lift in official interest rates in the current hiking cycle has been less in Australia, 400bps to 4.10% so far against 550bps to 5.50% in the US.
When Australia’s Q2 GDP report is released in early September, household consumption spending is unlikely to show more than zero real quarter-on-quarter (q-o-q) change based on the recent release of real Q2 retail sales, which fell 0.5% marking three consecutive quarterly falls. In contrast, consumers in the US continue to spend more, albeit at a declining pace. US GDP rose 0.6% q-o-q in Q2, and real consumer spending was up 0.4% q-o-q after rising 1.0% in Q1.
US households are not reducing their spending in the way that Australian households are cutting back. One reason for the different spending response to higher interest rates is that the US is a long-term fixed rate borrowing market. In the US a person who took out a 30-year fixed rate mortgage to buy a house two or three years ago feels no effect from rising official interest rates, unless he or she decides to sell their house and buy another on a new 30-year fixed rate mortgage.
In contrast, an Australian home buyer of a home two or three years ago taking out either a variable interest rate loan or perhaps a two-year fixed rate loan is now feeling every basis point and more of the Australian official interest rate hikes. Household debt as a percentage of household disposable income is also more than forty percentage points higher in Australia than the US adding to the relative pain of rising Australian interest rates.
Higher interest rates are cutting back Australian household spending and that is placing Australia closer to the brink of recession. However, there are factors that may work to cushion and possibly reverse the slide in spending.
The labour market is strong and is still generating strong employment growth as well as accelerating wage growth. Employment has lifted more than 100,000 in May and June and annual wage growth at a 10-year high 3.7% y-o-y according to the Q1 wage price index report is set to rise higher with the Q2 report due this week and then keep rising through at least the remainder of this year.
Also, net migration to Australia has soared over the past year or so. In 2022, net overseas migration was 387,000 and looks set to grow at least as much again in 2023. Those immigrants can source a big potential countervailing boost to household spending leaning against the reduction caused by higher interest rates.
The big lift in migration is also adding demand to Australia’s under-supplied housing market a factor likely to keep housing inflation bubbling for a while.
It is a very fine balancing act for the RBA. It has evidence of growth in household consumption spending slowing to a standstill taking some demand pressure off prices mostly for goods. The supply chain for goods and some services is improving, also reducing price pressure.
However, service prices are looking stickier than goods prices. House price (including house rental) inflation looks set to continue as the patchwork and slow policy responses to chronic under-supply of housing continues. Moreover, the poor and slow housing supply response continues while demand is lifting at pace with a rocket after-burner of record immigration.
Australian annual inflation is declining and that means that the worst of the monetary tightening is over. But it does not mean that it is finished. The RBA at this stage only has a “credible” path to return inflation to 2-3% target by late 2025, but not a convincing path in our view. We still see one or two more rate hikes ahead adding to the risk of even weaker household spending. Even if there are no more rate hikes the interest rate increases to date have taken the economy to the brink of recession. It is a much finer balance between achieving a soft landing or experiencing recession in Australia than it is in the US or even Europe in our view.