Sluggish Australian GDP growth in Q1 (+0.2% q-o-q, +1.3% y-o-y) plus some evidence that households are preferring to save rather than spend early in Q2 provide some leeway for the RBA to cut the cash rate further over the next few months. But that leeway is not great because there is also evidence in recent economic readings, including the Q1 GDP report, that demand is more likely to become stronger later this year and with growth in supply still constrained by poor productivity. In our view, higher inflation is still high risk to return late this year and in 2026.
Looking first at the Q1 GDP report, the moderating quarterly growth rate to 02% from 0.6% q-o-q in Q4 2024 was driven mostly by a 2.0% q-o-q fall in government investment spending (up 0.8% in Q4) together with a 0.8% fall in exports of goods and services (up 0.1% in Q4). Also, growth in household consumption expenditure was softer in Q1, up 0.4%, compared with up 0.7% in Q4.
Some expenditure components of GDP showed stronger growth in Q1 than in Q4, notably spending on dwellings, up 2.6% q-o-q compared with a 0.7% lift in Q4, but these increases amounted to less than the changes to household consumption expenditure, government spending and exports. The continuing and strengthening rise in spending on housing, however, should not be dismissed. Spending on housing has been a good leading indicator of GDP growth in previous cycles. It would be unusual if the accelerating spending on housing evident in the last few quarterly GDP readings did not lead to stronger general expenditure-based GDP.
Several other housing indicators are also strengthening including housing finance indicators and house prices almost generally across Australia. Government policy changes helping first-time home buyers plus lower home mortgage interest rates after the first two rate cuts are priming home-buying demand. That increasing demand is meeting a limited lift in supply of new housing where government initiatives to increase supply are still running up against longstanding constraints on supply in the sector – planning consent delays and costs; high costs of building materials; shortages of skilled labour; and mounting financial pressures on home builders.
The likely continuing strength of demand for housing relative to supply will, in our view, drive up house prices and rents at an increasing pace later in 2025 and in 2026. That is one reason why we do not see comparatively low inflation persisting much beyond the middle of this year.
We also expect the lift in housing demand to feed through to stronger household consumption spending later this year. The main reason why we expect stronger growth in household consumption spending to develop is that household disposable income is lifting strongly, up 1.4% q-o-q in Q1. Households chose to allocate much of that increase to saving rather than spending. The household savings ratio lifted to 5.2% in Q1 from 3.9% in Q4 and is high by historical comparison. The factors driving up household disposable income are still in play and strongly. Wage growth, around 3.4% y-o-y and probably rising, is a percentage point above inflation around 2.4%. Employment growth remains very strong. The calls on disposable income from taxes and mortgage interest payments are less than a year ago.
Household thinking in Q1 was beset by heightened uncertainty about the economic future driven in part but the disruptive changes from President Trump’s introduction of high tariffs threatening world trade and growth. That disruption has not gone away but the change towards negotiating trade agreements and in some cases walking back the biggest of the tariff increases has quelled the worst fears of global growth slowdown.
At the same time, in Australia the RBA showed it was responsive to possible downside risk to Australian economic growth and has moved from a policy position at the beginning of the year placing priority of ensuring lower inflation to one of fearing inflation less mostly because of softer than expected economic growth. It has become dovish, providing two rate cuts so far and indicating more to come.
Households have the wherewithal to spend more freely. We see them applying less of quite rapidly rising household disposable income to saving and more to spending over the next few quarters. They may even cut into savings balances to fund spending.
If we are right, that additional household demand will run up against limited supply. Businesses in Australia have been lifting investment spending at meagre pace for years. Productivity has remained very low as a result. Real GDP per hour worked was unchanged in both Q4 and Q1 and in Q1 was down 1.0% y-o-y.
Relatively strong growth in demand as 2025 progresses set against poor supply spells higher inflation in 2026. Other factors adding to rekindling inflation include wage costs rising faster than inflation driven by the still very tight labour market.
While the RBA may be able to get another cash rate cut or two away over the next few months, they will add to the reason why inflation will lift in 2026 and why the next rate hiking cycle is likely to start in the second half of next year.