The RBA’s June decision to hike the cash rate another 25 basis points (bps) to 4.10%, plus a subsequent speech by the RBA Governor Lowe focusing on the stickiness of inflation and the Q1 2023 GDP release showing a record annual fall in productivity all point to the RBA hiking the cash at least one more time over the next few months. We concede that the cash rate will peak higher than we thought likely before the RBA meeting, but we doubt whether the peak will be above 4.60% as some are forecasting.
The main reason why we are not as hawkish on the cash rate peak as some is that there is ample evidence that household consumption spending has been slowing for some time and it is on the brink of a more precipitous decline that will undermine inflation pressures in the economy and the capacity of workers to push for higher wages.
Returning to why the RBA hiked the cash at both the May and June policy meetings and why it is indicating the possibility of more rate hikes ahead the answers are that inflation is too high still (6.8% y-o-y on the April month CPI), service prices are showing signs of staying stickily high and wage growth although not yet too high, based on the Q1 wage price index at 3.7% y-o-y, is threatening to become too high when taken together with unusually low productivity.
As RBA governor Lowe pointed out in his speech last week, unit labour costs (the combination of wage growth and productivity) are lifting 7.5% y-o-y and rising. Unit labour costs have a strong correlation with the CPI, so unless the growth in unit labour costs moderates the task of getting inflation down to 2-3% range becomes more protracted and difficult. The most recent indications on the wage front indicate accelerating annual wage growth ahead while the latest reading on productivity in the Q1 GDP report is that it has worsened to -4.6% y-o-y.
If growth in unit labour costs stay stuck at 7.5% y-o-y and higher near term, the RBA has little alternative but to keep hiking the cash rate. Indeed, while growth in unit labour costs stay as high as they are currently the only way to offset that pressure on inflation is to reduce growth in demand in the economy substantially. This need to reduce slowing demand growth even more is where the pressure on the RBA to keep raising the cash rate comes in to play, even though it is evident that the earlier run of rate hikes is making the cost-of-living crisis worse for a growing part of the community.
The outlook for unit labour is not entirely bad in our view. On the wage growth part of unit labour costs, it is likely that the pressure will stay high for the next three to six months and mostly because of notable relatively high pay deals coming in to effect soon. The 15% age-case sector pay rise; the lift in the minimum wage related awards by 5.75% and 8.6% for the few workers on the minimum wage; public sector pay increases between 4-4.5%; and several private sector deals between 4-5% all coming in to effect soon imply that by the end of this year the wage price index will be up nearer to 5% y-o-y rather than the 4% forecast by the RBA.
Looking beyond this year, however, slowing demand in the economy – reinforced by one or two more RBA rate hikes, plus the relatively high wage increases in 2023 are likely to push up the unemployment rate, and probably to higher level than the RBA is forecasting currently. The RBA’s latest (May 2023) economic forecasts show the unemployment rate rising from 3.7% y-o-y currently to 4.0% at the end of 2023 and 4.4% at the end of 2024. We see the unemployment rate pushing up nearer to 5% in 2024, pronounced deterioration in labour market conditions that will take a lot of steam out of wage negotiations in 2024.
In short, while rising wages continue to place upward pressure on unit labour costs over the next few months that pressure is likely to reduce through 2024 as much weaker labour market conditions kick in.
Concerning the productivity part of unit labour costs, we see the record annual fall in GDP per hour worked in Q1 2023, -4.6% y-o-y, as probably the low point for the annual fall in productivity. Productivity has been unusually poor over the past three years and it seems that some, if not much, of the unusual weakness relates to impact of the pandemic – keeping labour on the books during the lockdowns when output was severely curtailed plus the rush to employ more people in service industries (where productivity is difficult to measure) when restrictions were lifted.
Productivity has been especially poor over the past year and much of that relates we believe to the pandemic lockdowns and release from lockdowns. Hence GDP per hour worked was at its worst in Q2 2022, -3.0% q-o-q. In Q1 2023 GDP per hour was still down, but only 0.3% q-o-q. If it falls a similar amount in Q2, because of the much bigger fall in Q2 last year, the annual change in GDP per hour worked would reduce to -2.0% y-o-y from -4.6% in Q1.
Annual growth in unit labour costs, even allowing for wage growth nearer 4% y-o-y would reduce to around 6% y-o-y still much too high for comfort and still needing not just a base effect improvement in annual productivity change but a genuine improvement to at least positive 1.5% y-o-y to provide the RBA with confidence that it will get inflation down to 2-3% target over the next two years.
While annual growth in unit labour costs remain uncomfortably high, containment of demand remains the only antidote to high inflation. On this front, the biggest component of aggregate demand, household consumption, is decelerating. In the latest Q1 GDP data, household consumption rose only 0.2% q-o-q, compared with 0.3% in Q4 2022, 0.8% in Q3 2022 and 2.2% in Q2 2022. The deceleration in discretionary household consumption expenditure has been even more pronounced, -1.0% q-o-q in Q1 2023, 0.3% in Q4 2022, 1.6% in Q3 and 3.8% in Q2.
Australian households are clearly cutting back their spending in response to higher interest rates and that process is likely to intensify as the full effect of past RBA rate hikes flows through plus any further rate hikes in future. Weak bordering recessionary growth in Australian aggregate demand lies ahead and that will serve to ease tight labour market conditions, reduce annual wage growth next year and help to ensure inflation returns to target band in 2025. There is little reason for the RBA to hike the cash rate more than one or two more times.