While Australian inflation could track lower in the first half of 2025 signs are showing that it will start to rise again later in 2025 and in 2026. Those signs include the persistently tight labour market and current round of high wage negotiations, growth in domestic demand running faster than growth in Australian output and the weakening Australian dollar exchange rate. The issue facing the RBA’s interest rate setting committee is will the near-term reduction in inflation last long enough to allow the cash rate to be cut.
We see the RBA cutting the cash rate in the middle months of 2025, but not by much. As the current signs of higher inflation on the horizon turn to actual higher inflation in late 2025 and early 2026, that will prompt the RBA to start hiking the cash rate in 2026.
Our view is at odds with the growing consensus that the RBA will cut the cash rate at the next interest rate setting meeting in mid-February by 25bps to 4.10% and will continue to cut through to early 2026 taking the cash rate down to 3.60% or less. Being different from the forecasting pack requires some explanation.
The first point of explanation is that labour market conditions are showing no signs of easing to the point that will allow annual wage growth to ease to around 3% y-o-y, a necessity for inflation to stay inside the RBA’s 2-3% band in our view given that productivity is weak and still falling. The December 2024 labour force report released last week shows total employment up 56,300 in the month, about double what was expected, taking annual employment growth in 2024 to 444,400, up 3.1% y-o-y.
In November 2024, the RBA forecasted that employment growth would be 2.6% y-o-y in December 2024 and the unemployment rate would be 4.3% (it was 4.0% in the figures last week). The labour market was tighter than the RBA expected at the end of 2024 and we see reasons to expect the labour market to stay tight in the first half of 2025 running at odds with the RBA’s November forecasts of annual employment growth moderating to 2.2% y-o-y by June 2025 and the unemployment rate lifting to 4.4%.
The main reason why we see the labour market staying tight is that strong growth in public sector employment will continue in 2025 because the shortages of staff in frontline services in the policing, health, education, transport and national disability support remain acute. Growth in public sector employment, the mainstay of total employment growth, shows no signs of moderating in 2025, rather it is growing at least the same pace as in 2024.
Moreover, the acute shortages of labour in key parts of the public sector have been adding fuel to union wage demands. While the state governments are trying to hold out against wage demands their covid-era freezes on pay have shifted to offering above 3% per annum over the next three-years with offers continuing to rise as industrial disputes continue. Large public sector pay rises, nearer to 4% per annum and more over the next three-years are likely to be settled over the next few months and that would mean that the wage price index rising 3.5% y-o-y in Q3 2024 will not moderate to 3.2% y-o-y by the end of 2025 as the RBA forecasted in November, but will be rising up through 4.0% y-o-y.
Another building pressure point keeping the labour market tight is revival of private sector employment growth. Weak private sector demand in the economy through the first half of 2024 meant soft growth in private sector employment, but that showed the first signs of a stronger turn late in 2024. The latest November 2024 ABS quarterly job vacancies series showed the first quarterly increase in Job vacancies since May 2022. Job vacancies had been coming down off a huge surge with the easing of pandemic restrictions, but even with the reduction still stood more than 50% higher than in February 2020 at the start of the pandemic.
The rise in job vacancies in the three months ending November 2024, up 4.2% q-o-q to 344,000 implies tighter labour market conditions ahead. Also significant was that the lift in job vacancies came mostly from the private sector, up 5.2% q-o-q, against a 2.5% q-o-q lift in public sector job vacancies. The lift in private sector job vacancies in the three months to November coincides with evidence of improving growth in household spending in October and November.
If stronger private sector employment growth starts to reinforce continuing strong growth in public sector employment, the unemployment rate is likely to stabilize around the 4.0% level and could start to fall again. Through 2025, the unemployment rate will be notably less than the 4.3-4.5% unemployment rate that RBA researchers view as consistent with a non-accelerating inflation rate.
The continuing tightness of the labour market is likely to help promote stronger growth in Australian domestic spending. Other factors promoting stronger domestic spending growth include now rising real household disposable income and a weakening Australian dollar shifting Australian demand away from increasingly expensive imports and towards Australian produced goods and services.
The problem is that Australian production will be stretched to keep pace with any additional growth in demand. Productivity is still going backwards at about 0.5 percentage points per year. Demand pressuring supply in the economy as well as wage pressures are both likely to rekindle as factors supporting inflation later in 2025.
The RBA’s leeway to cut the cash rate is limited to the brief period in early to mid-2025 when inflation looks contained. Beyond that period, we see signs of rekindling inflation pushing the RBA to start hiking the cash rate again in 2026.