At some point the RBA will become confident that the forces driving above-target inflation are weakening enough to bring annual inflation back within 2-3% range over the next two years or so. Even though the RBA has delivered major monetary tightening over the past year or so including abandoning control of the 3-year bond yield at 0.10% late last year, delivering eight consecutive monthly cash rate hikes since May from 0.10% to 3.10% and moving from quantitative easing to quantitative tightening, enough tightening to make a reasonable case that strong demand will moderate and help to reduce inflation, recent Australian economic reports remain too strong for the RBA to be confident that a return to low inflation over time is in the bag.
The latest Q3 GDP report released last week showed still strong real economic growth, up 0.6% q-o-q, 5.9% y-o-y. More importantly, domestic spending remained the driving force for GDP growth, especially household consumption, up 1.1% q-o-q, contributing 0.6 percentage points to GDP growth in the quarter. Private investment spending also contributed 0.2 percentage points to growth.
Looking at Q3 GDP growth is like looking in the rear-view mirror at where the economy was three months ago and more, but the strong economic growth back then with the time lags involved as employers assess and act on their workforce needs is driving demand for labour around now. That demand still seems to be strong. The November labour force report is out on Thursday and is likely to show another rise in employment and the unemployment rate holding down around 3.4%, the lowest reading since 1974, and low enough to ensure that upward pressure is still building on annual wage growth.
Annual wage growth is threatening to become high enough to compromise the RBA’s aim of returning inflation to 2-3% target. The latest Q3 wage price index report showed wages up 1.0% q-o-q, 3.1% y-o-y. Annual wage growth will almost certainly push up towards 4% y-o-y in the next two quarterly readings out in February and May next year, presenting a real challenge to getting annual inflation down to 3%. The RBA needs to see some evidence of weakening in the labour market – the unemployment rate moving up towards 4% – to allow it to view annual wage growth rising to 4% and more as a temporary development that will fade. Once that occurs, the RBA is in a position to call time on rate hikes.
Labour market change lags by several months change in demand in the economy which means there is risk that the RBA will still be tightening monetary policy when the economy has tipped weaker. Currently, there are signs of weakening in housing activity that are likely to broaden as the full impact of past RBA rate hikes are felt by borrowers and a greater proportion of earlier fixed rate borrowers face higher interest rate loan rollovers in the early months of 2023.
What signs there are of weakness in housing are still more than offset by strength in non-housing spending. October retail sales showed a small dent, falling 0.2% m-o-m, but anecdotal reports point to a rebound in spending in November.
The lack of consistent evidence of softening Australian domestic demand so far means that tight labour market conditions will persist in to the early months of 2023. The RBA will need to deliver another 25bps cash rate hike to 3.35% when it meets next in February, and the risk is migrating towards more hikes beyond.
The higher the RBA takes the cash rate, the greater the risk of a sharp pull-back in domestic demand and of the economy falling in to recession. The RBA is in the tricky business in the current policy tightening cycle of trying to dial a soft-landing for the economy – weaker, but not negative GDP growth with the unemployment rate rising a little, but not too much. However, the resilience of demand and the labour market, are presenting a risk case that the RBA hikes too much and the economy tips in to recession late next year.
The tipping-point from economic strength to economic weakness is impossible to observe in real time and it is one of several reasons why central bank policy tightening phases mostly generate harder rather than softer landings.
Our base case remains that the RBA hikes the cash rate once more by 25bps to 3.35% in February. The RBA will be acutely aware that if it waits for evidence that the economy and the labour market have tipped weaker before completing the policy tightening cycle it is almost certainly shoving the economy over the tipping point and in to recession. The cost to the RBA of completing the rate hiking cycle in February is that it has to face down calls for more rate hikes as the economic numbers take time to weaken. Almost certainly, the cash rate would need to stay at its peak for longer, probably through the rest of 2023.
A growing risk case is that the RBA hikes one or two more times beyond the February hike. That may place the cash rate peak close to 4% in April or May, heightening the risk of recession and making it likely that the peak cash rate would last only two or three months ahead of an easing cycle starting in late 2023.