Our current view about the cash rate outlook is based on the economic forecasts produced by the RBA in its latest (February) Monetary Policy Statement. These economic forecasts seem consistent with two or three more 25bps cash rate hikes taking the cash rate to a peak of 3.85% or perhaps 4.10% by May and then holding that cash rate peak to early 2024 before starting to cut the cash rate.
Whether our current cash rate view proves to be accurate will depend largely on whether economic conditions track reasonably closely with the RBA’s latest economic forecasts. Monitoring economic data is one of the RBA’s key activities when judging if its economic forecasts need to be adjusted.
While much recent commentary has related to inflation running too high and the risks around it taking time to subside towards the RBA’s 2-3% target, there is a tentative hint in the monthly labour market data of softening labour market conditions that may be a first sign that inflation will return to target and perhaps a little earlier than the RBA’s current timeframe forecast of mid-2025.
The latest January labour force report shows back-to-back monthly falls in employment, -19,900 in December and -11,500 in January. With these falls in employment over the last two months included, employment is still up 394,100, or 3.0%, in the 12 months to January 2023.
Because of the December and January reductions in total employment, the unemployment rate lifted to 3.7% from 3.5% in both November and December. The falls in employment in both December and January and the rise in the unemployment rate could prove significant relating to the RBA’s latest economic forecasts which have annual employment growth sliding to 2.4% in June 2023 and 1.5% in December 2023 with the unemployment rate in the two forecast periods at respectively 3.6% and 3.8%.
At face value, the softer December and January labour force reports taken say that the RBA may need to revise lower forecast employment growth to respectively 2.0% and 1.0%, or less, for June and December 2023 with unemployment rates at 3.9% and 4.1% respectively. If the RBA makes these forecast changes in the May Monetary Policy Statement it would also need to adjust its inflation forecasts a notch or two lower through 2024 and the first half of 2025. That would see forecast headline and underlying inflation returning to target range in the second half of 2024.
If these forecast changes occur in the May Monetary Policy Statement, the RBA would not need to hike the cash rate as much over the next three policy meetings, perhaps only one or two more hikes of 25bps, to 3.60% or 3.85% at most.
The problem is that while the key labour force data look softer at face value, the RBA cannot be certain whether the softness is masking underlying strength. The commentary from the Australian Statistician accompanying the January labour force report highlight some of the unusual factors in play in January this year. More unemployed people than usual in January this year compared with Januarys on average said they had a job to go to in the future. There were also more people than usual in January on holiday and not employed or saying they are employed but not returning to work until later in the month. There is a sense that the softness in the employment data could be temporary and even if it proves not to be temporary it will take more monthly labour force readings to prove the case one way or the other.
However, there is another data release this week that could influence the RBA to take a chance that the December and January labour force reports are showing the beginnings of a softening labour market. The Q4 wage price index out on Wednesday is expected by the RBA and the market to show a rise of 1.0% q-o-q, 3.5% y-o-y. If it comes in at that increase, or higher, it is consistent with the RBA’s February MPS wage forecast trajectory of annual wage growth lifting to 4.1% in June 2023 and 4.2% in December, high enough to slow inflation returning to target band until mid-2025.
A low-side Q4 wage price index outcome less than 1.0% q-o-q, 3.5% y-o-y would paint a different picture, providing added reason for the RBA to take the soft labour force readings more at face value and to consider downward adjustments to its 2024 and 2025 inflation forecasts.
Essentially, as supply bottlenecks continue to resolve continuing to take steam out of goods prices and the lingering post covid-restriction surge in demand for services runs its course it is the strength of the labour market and the associated wage growth generated that will determine whether and how soon inflation returns to target range.
Understandably, the RBA is worried that past high inflation could drive compensating pay claims. The risk of a price/wage spiral developing is high while unemployment is very low. This risk explains why the RBA is proclaiming strongly that more rate hikes will be needed to contain inflation.
The last two labour force reports seem to limit the risk that wage growth will chase recent high inflation, but more evidence of receding risk is needed. That evidence would be reinforced by a low-side wage price index report this week. Equally, an as expected, or high-side report would cause the RBA to view cautiously the last two labour force reports and stick with its current economic forecasts.