The timetable for the RBA’s initial rate cut has turned into an endless hurdle race where the race is getting both longer and some of the hurdles along the way are getting higher. Using the guide provided by the RBA when its forecasts were updated last in early February a rate cut either in Q3 or Q4 this year seemed to be on the cards. Notwithstanding RBA commentaries at the time of its mid-March interest rate setting meeting that it still seemed to be on track to get inflation back inside 2-3% target range by late next year – a pre-condition to start cutting the cash rate – economic reports over the past month point to a more challenging and lengthier task getting inflation back inside target. The timetable for the initial rate cut is drifting into 2025 and worse before that happens the very small likelihood that the RBA may need to hike the cash rate further in the meantime is starting to grow.
Some of the growing problems challenging the initial rate cut timetable include potentially too strong aggregate demand and in particular too strong demand for housing, the tightness of the labour market and too high wage growth, the approaching boost to real household disposable income from tax cuts and potential renewed supply chain disruptions destroying the major dampening influence on inflation from stable or falling prices for goods prices.
The list of challenges is substantial and until it moderates with greater certainty the RBA’s least line of regret is to leave the cash rate where it is at 4.35%. If some of the challenges show signs of not moderating and become worse, then the RBA will need to consider hiking the cash rate further.
Taking each challenge in turn the first is growth in aggregate demand. To limit and bring down inflation the high growth in aggregate demand that came in the wake of government payments boosting household income during covid lockdowns in 2021 and 2022 needed to be reduced towards the much lower growth in supply of goods and services. Essentially, the rate hikes delivered by the RBA in 2022 and early 2023 were designed to reduce excessive growth in demand taking the cash rate up from an emergency and demand-supporting level of 0.10% to demand-restraining level of 4.35%.
At the total or aggregate level demand in the Australian economy has been brought back closer in line with aggregate supply and has helped to bring inflation down on the quarterly CPI readings from a peak 7.8% y-o-y in Q4 2022 to 4.1% in Q4 2023. The monthly CPI readings for January and February point to the possibility that inflation in Q1 2024 may have fallen to around 3.5% y-o-y. Slowing growth in aggregate demand has done the heavy-lifting reducing inflation so far, but there are signs that aggregate demand growth may not stay soft.
Household spending represents the lion’s share of aggregate demand at more than 60%. Within household spending retail spending growth weakened sharply through 2023 from annual growth of 7.7% y-o-y in December 2022 to 0.8% y-o-y in December 2023. Early this year retail spending lifted 1.1% m-o-m in January and 0.3% in February taking annual growth up 1.6% y-o-y, not strong annual growth, but off the 0.8% y-o-y cycle low-point annual growth reading set in December last year. Special events such as the Taylor Swift concerts may have driven some of the improvement in retail sales, but it is also likely that higher wage growth and rising household disposable income played some part as well.
Another part of household spending that is clearly running well ahead of supply is spending on home purchase and housing rent. The monthly CPI report shows accelerating house price pressures with new dwelling purchase prices rising from 4.8% y-o-y in January to 4.9% y-o-y in February and housing rent prices rising from 7.4% y-o-y in January to 7.6% y-o-y in February. Housing supply is proving to be very hard to lift with home building approvals and commencements languishing at a third of the rate of growth of population.
The increasing risk is that house and rent price growth will accelerate and halt and possibly reverse progress reducing general inflation. Excess housing demand may become a more important factor in determining when the RBA can start to cut interest rates.
The tightness of the labour market has also become a factor that may delay when the RBA can cut rates. The February labour market report with its out-sized 116,500 rise in employment and 0.4 percentage point fall in the unemployment rate to 3.7% rendered marginal the softening in labour market conditions so far and heightened the risk of wage growth above 4% y-o-y persisting for longer potentially underpinning inflation well above 3% y-o-y. The RBA now needs signs of marked weakening in the labour market over the coming months and combined with evidence of marked improvement in labour productivity. The combination is not impossible but is equally not a high probability and even if it occurs will take data reports over many months to prove.
The signs of strengthening household spending and less weakening than expected in labour market conditions mean the approaching boost to household disposable income from income tax cuts on July 1 have become another factor that the RBA cannot pass off as unlikely to underpin inflation. Amid firmer economic conditions than previously thought likely the tax cuts may flow more towards boosting household spending rather than household saving. At the very least, the RBA will want a few months of data after the tax cuts are introduced to assess their impact.
Another factor coming into play is the international global supply chain. War and rising political tensions have all but closed the Red Sea to shipping. The Baltimore Bridge accident has closed the key US port for several weeks. Tensions in the South China Sea continue to mount. The cost of shipping goods is rising again and threatens to take away the biggest factor reducing inflation – the stabilising/falling price of goods.
All told the RBA’s race to get inflation consistently back inside 2-3% target is getting longer with hurdles to surmount threatening to get bigger than smaller. An initial cash rate cut in 2024 is becoming a more forlorn hope.