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Whether the softer patch in the labour market over the past month or two stays soft, or takes a turn for the better over coming months is likely to hold the key to the outlook for Australian interest rates. The first reason why the outlook for the labour market has become so important is that the household sector will need to be doing the initial heavy lifting if the economy is to successfully rebalance economic growth drivers as mining investment spending falls. If households are to perform this task by spending more, they will need to be confident that their income is not under threat. This is where a strong labour market comes in; providing the comfort that, even in the event of unemployment, jobs are relatively easy to come by.
The second reason why labour market conditions are critical for the interest rate outlook is through their link to the inflation outlook. A soft labour market weakens wage bargaining power, as it has over the past few years. Low, soft wages growth means that even if the inflation rate is being buffeted by temporary inflationary influences as has been the case at times over the past year, it is possible with a reasonable degree of confidence to say that inflation will settle down over the medium-to-longer term, much as the RBA is forecasting.
What the most recent labour force data for June seem to be indicating is that the quite strong revival in employment between December 2013 and March 2014 (employment grew by 90,600 averaging 30,200 a month) softened markedly between March and June when employment grew 20,100 over the three months averaging 6,700 a month. The strong employment growth in earlier period was enough to edge the unemployment rate down from 5.9% in December to 5.8% in March, whereas the softer employment growth in the more recent period has seen the unemployment rate move up to 6.0% in June.
If the softness in the labour market in the most recent three month period persists it is highly likely that growth in household spending, both on housing and consumer goods, will grow only modestly at best, reliant almost entirely upon higher household wealth as a driver of stronger household spending. Also, very weak wages growth is likely to linger for longer and annual inflation would probably fall towards the middle, or even the low, part of the RBA’s 2-3% target range over the next year or so. In these circumstances, the RBA would hold the cash rate at 2.50% for a few more months, but would then probably cut the cash rate to try and lift the spirits of the household sector and encourage more borrowing and spending.
In contrast, if the labour market revives (which we judge to be the more likely prospect) over the next few months, household spending will probably lift sufficiently to underpin annual economic growth around 3.1% long-term trend. Even with a return to stronger labour market conditions, it will take time for any general upward pressure on wages to develop. While annual wages growth continues to languish around the recent readings of 2.6% y-o-y, the RBA is likely to continue to forecast inflation inside target band out in 2015 and early 2016, the relevant forecast horizon for what it does with monetary policy in the next few monthly policy meetings. Thus even if the labour market strengthens over the next few months, it is unlikely that the RBA will lift the 2.50% cash rate until it has a substantial set of data providing compelling evidence that economic growth is lifting strongly. It is unlikely, that such evidence will be available until March 2015, at earliest.
Are there any hints in the June labour force data of improvement in the making? Possible clues of future improvement are that employment growth in the month at 15,900 was the best in three months. Also, if the labour market is going to pick up pace it almost certainly has to be led by New South Wales – the state that has enjoyed greatest lift in household wealth; the state where housing remains under-supplied; and the state influenced by far the most generous state government spending intentions. June was a better month for New South Wales with employment lifting by 10,000 in the month and the unemployment rate unchanged at 5.7% (below the 6.0% national average).
We expect these tentative signs of labour market improvement to build momentum over coming months, but we also admit that this is a close call. If our labour market forecast is right most likely the RBA will start to seriously consider lifting the cash rate around March 2015. If we are wrong on our labour market call a cash rate of 2.50%, or less, will be in play for much longer. Whatever the future holds for the labour market, the bottom line is that there is very little risk that the cash rate will be any higher than 2.50% over at least the next eight months. It is rare to have that degree of certainty about the official interest rate outlook.