Last week we took the signs of easing labour market conditions contained in the September labour force report as reason to expect the RBA to stay on hold at its next interest rate setting meeting on 7 November. What a difference a week can make in economics. The Q3 CPI released last week makes it clear that inflation is sitting too high relative to the RBA’s August Monetary Policy Statement economic forecasts and a material upward revision to those forecasts is likely in the November Monetary Policy Statement. As a result, the RBA is likely to announce a 25bps cash rate hike at the November Board meeting taking the cash rate up to 4.35% and will probably announce a further 25bps rate hike to 4.60% in December.
Normally we would produce an Economic Roundup article at the month-end, but that will now come next week incorporated in the usual beginning of month Market Drivers article. The change to our longstanding view that the cash rate would stay on hold at 4.10% takes precedence and needs explaining.
The first point is that the headline and underlying annual (trimmed mean) inflation on the Q3 results of 5.4% y-o-y and 5.2% y-o-y sit too high and make it close to impossible for the RBA to achieve their August forecasts of 4.1% y-o-y for the headline CPI and 3.9% for trimmed mean inflation in Q4 2023. The quarter-on-quarter changes in Q4 for the CPI and trimmed mean would need to be around 0.6% to achieve the August forecasts compared with the Q3 q-o-q results of 1.2% for both the CPI and the trimmed mean.
Given the inflationary pressures running at present in many service prices and petrol prices, the Q4 2023 CPI and trimmed mean looks like coming at least 1.0% q-o-q. That means the RBA will need to revise upwards its annual inflation forecasts for end-2023 by around 0.4 percentage points to 4.5% for the headline CPI and 4.3% for underlying inflation.
This “material” upward revision to the RBA’s near-term annual inflation forecasts also sets the scene for upward revisions to its 2024 inflation forecasts carrying into 2025.
A second point of explanation arising from the Q3 2023 CPI report highlights why high inflation looks like staying sticky in 2024 and 2025. The Q3 CPI report shows that higher service prices and domestically sourced inflation are mostly responsible for inflation failing to decelerate as much as the RBA had hoped.
Inflation sourced internationally (tradables inflation) rose in Q3 by 0.7% q-o-q and 3.7% y-o-y whereas inflation sourced here in Australia (non-tradables inflation) rose by 1.3% q-o-q, 6.2% y-o-y. It is high domestically sourced inflation that is likely to be of increasing concern to the RBA and a factor requiring higher interest rates to suppress demand further and bring it under control.
Also, the battle to bring inflation down over a reasonable time was always going to be a contest between declining goods price inflation as international supply chains improved and residual strength in service prices. The Q3 CPI showed annual change in goods prices down to 4.9% y-o-y, but still uncomfortably high whereas service price inflation came down only modestly to 5.8% y-o-y and remains far too high for the RBA to have any hope of achieving its 2-3% inflation target in the next 18 months or so.
Many service prices showed higher than 5.8% y-o-y annual increases in Q3 with some of the more notable being restaurant meals 6.1%; hairdressing 6.7%; financial services 6.9%; housing rents 7.6%; and insurance 14.6%. Most of these will moderate only slowly over the next year and some may even lift higher.
The Q3 increase in housing rent at 2.2% q-o-q was less than it otherwise would have been because of a one-off 15% additional lift in Commonwealth rent assistance. Other special cost-of-living relief such as energy bill rebates and the higher child-care subsidy that came into effect on 10 July helped to reduce inflation in electricity charges and child-care costs in Q3. Without these cost-of-living measures CPI inflation would have been higher than 1.2% q-o-q in Q3.
While these cost-of-living measures helped to moderate the Q3 inflation result there will be some give back as inflation in the items affected bounces back up to trend quarterly change in Q4 2023 and beyond.
Also, while these measures help households to cope with higher prices, they also serve to prevent households from adjusting their spending away from higher priced items. Households spending less on items where prices are rising fastest is a mechanism that reduces demand relative to supply helping to cap price increases and contain inflation. Cost of living relief measures by holding demand higher can act to slow progress getting inflation down.
Returning to likely adjustments to the RBA’s inflation forecasts in November, beyond the around 0.4 percentage point lift in annual inflation to 4.3% to 4.5% range for end-2024, the factors listed earlier also indicate a need to lift by around 0.2 percentage points end-2024 inflation forecasts to 3.3% to 3.5% range and end-2025 to 3.0%. These likely adjustments to the RBA’s forecasts mean that inflation does not fall inside the RBA’s 2-3% target band until 2026.
Last week, RBA Governor, Michelle Bullock, repeated her comment that the RBA Board has low tolerance for inflation remaining higher than where it was forecasting in August. Any material upward adjustment to the RBA’s inflation forecasts would mean that higher interest rates would be required.
Based on higher-than-expected inflation in Q3 and what was driving it, a material lift in the RBA’s inflation forecasts seems unavoidable in the November Monetary Policy Statement. That is why we have changed our interest rate forecasts and now expect a 25bps rate hike to 4.35% next week followed by a further 25bps hike to 4.60% at the early December RBA Board meeting.