In the words of RBA Governor, Michelle Bullock, the RBA is unlikely to cut the cash rate over the next six months and the RBA’s latest economic forecasts of too strong aggregate demand relative to economic output and inflation taking longer to come inside 2-3% target band imply an even longer wait. While there is not quite any need to hike the cash rate in the near term that is where the risk lies for the cash rate in the near term. Our view remains that the cash rate will be at 4.35%, or possibly higher, through to Q2 2025.
The RBA’s latest economic forecasts contained in the August Monetary Policy Statement and compared with the previous forecasts published in May show that the economy is expected to grow more strongly in the near term and that inflation will take longer to fall consistently below 3%.
Taking the RBA’s economic growth forecasts first, they forecast that GDP at the end of this year (Q4 2024) will be up 1.7% y-o-y, a small upward revision from 1.6% forecast back in May. On the face of it, that minor upward revision does not appear to imply too strong a growth in aggregate demand, but it is the revisions to forecasts of the components of growth in demand in the economy and productivity that give cause for concern.
Forecast growth in spending on investment in the economy that adds to productive capacity or aggregate supply has been revised lower. In May Forecast business investment was +0.7% y-o-y in Q4 2024 but in August is revised down to +0.1% y-o-y. Annual growth in dwelling investment is forecast to fall for longer through to Q2 2025 worsening under-supply of housing in the near term.
While the RBA’s near-term forecasts of private investment spending have been revised weaker in the August MPS, forecasts of household consumption spending and public, or government, demand have been revised higher. Household consumption is forecast to increase 1.5% y-o-y in Q4 2024 (May forecast up 1.3%) and public demand is forecast up 4.3% y-o-y in Q4 2024 (May forecast up 1.5%).
The big driver of excessive demand in these forecasts is clearly the high real growth in government spending and accounts for why the RBA is going public saying that high growth in government spending is not helping the task of reducing inflation inside target band.
Excessive demand is being prolonged by too much government spending at a time when output growth is weak because labour productivity is not lifting as much as hoped for in the RBA’s earlier forecasts. In the August forecasts labour productivity lifts by only 0.1% y-o-y in Q4 2024 against +0.8% in the May forecast.
The diminishing prospect of a strong pick-up in labour productivity is also causing the RBA to worry that wage growth around 4% y-o-y is too high to bring inflation down to target over the next year or so.
The changes in the RBA’s inflation forecasts in August relative to May are influenced primarily by excessive demand persisting longer than previously forecast as well as the impact of various government “cost-of-living” reduction measures. The “cost-of-living” reduction measures reduce headline CPI inflation over the next year briefly below 3% y-o-y in Q2 2025 (2.8% in the August forecasts against 3.2% in the May forecasts) but at the cost of higher inflation beyond. Q4 2025 CPI inflation is revised upwards in August to 3.7% y-o-y from 2.8% in the May forecasts. The RBA now forecasts CPI inflation to stay above 3% throughout 2025 rather than coming inside 2-3% target band in the second half of 2025.
CPI inflation consistently inside target band is now pushed out to 2026 in the RBA’s latest forecasts when it will have been above target for five years, other than perhaps a quarter or two in the first half of 2025 reflecting the cost-of-living subsidies. The RBA is likely to place even more emphasis on underlying inflation measures in 2025 to read through the volatility of the headline CPI and to inform policy decisions.
Underlying inflation, as measured by the trimmed mean, came in a touch higher than the RBA expected in Q2 2024 at 3.9% y-o-y against 3.8% forecast in the May MPS. The RBA’s August forecasts show underlying inflation at 3.5% y-o-y in Q4 2024 (May forecast 3.4%) and 2.9% y-o-y in Q4 2025 (May forecast 2.8%). These forecast changes highlight that the RBA already worried about high and sticky inflation back in May is a little more concerned about high and sticky inflation in August.
If the RBA is to become less concerned about the inflation outlook, a pre-condition for starting to consider reducing the cash rate, it will need to see a series of data releases relating to demand and output that allow it to start moderating its inflation forecasts. That could occur, but the probability is low while government spending growth is as strong as it is at present.
While the RBA’s inflation forecasts stay where they are, the RBA will need the benefit of Q3 and Q4 2024 GDP and CPI reports to provide comfort that it is on track. It will take until early March next year before all of those reports are released, which is why we pencil in Q2 2025 as the earliest point when the RBA may be able to reduce the cash rate below 4.35%. If the RBA finds cause over coming months to revise its inflation forecasts higher it will be even longer before the cash rate is below 4.35%.