The RBA left the cash rate unchanged at 1.50% last week defying around half of market analysts calling for a rate cut. We did not expect a rate cut last week, but we recognise that the commentary accompanying the RBA’s decision and the changes to the RBA’s economic forecasts in the subsequent quarterly Monetary Policy Statement imply that the RBA could cut the cash rate at some point over coming months if a key precondition is met – the labour market softens. Our view remains that this precondition will not be met and that the cash rate stays on hold, but it is a close call.
In the quarterly Monetary Policy Statement, the RBA has lowered its near-term annual GDP growth forecast to 1.75% in mid-2019 although still picking up pace to its previous forecasts of 2.75% in 2020 and 2021. The RBA’s inflation forecasts have been edged lower in 2020 and 2021 to 2.0% from 2.25% previously. Over the past three months the RBA has become more concerned about weak growth in real household consumption spending and slow growth in household disposable income. If these trends in growth in household income and spending were to persist the RBA would probably find itself in a position where it would need to downgrade further its forecasts of real GDP growth and inflation and the case for cutting the cash rate would become compelling.
The RBA is unconvinced, however, that growth in household disposable income will stay weak. The labour market remains strong. Employment grew strongly again in Q1 2019, job vacancies are at a record high and the unemployment rate is holding down around an 8-year low 5%. Wages growth is also slowly edging higher. Many workers in the private sector are coming off protracted periods of wage freeze and new wage settlements are running around 3% annual increase. There are sound reasons to expect wages growth to continue to lift slowly.
The latest Q1 wages report is due this week and is expected to show a rise of 0.6% q-o-q, 2.3% y-o-y, still quite slow but not unduly low, especially when set against the latest annual rise in the CPI of only 1.3% y-o-y. Real wages growth is up to 1% y-o-y in Q1 2019 compared with 0.5% in Q4 2018 and flat or slightly negative through 2017 and much of 2018.
The RBA will be watching the Q1 wages report to help to judge whether its forecast that wages growth will continue to slowly improve is still reasonably based. There are other numbers, especially employment and unemployment numbers, that are even more important for the RBA to fine tune its wage growth forecasts.
Wages growth is ultimately driven by the supply and demand for labour. If the pool of labour resources is growing faster than demand for labour, the unemployment falls. A falling unemployment rate does not necessarily drive wages higher, but as the unemployment rate falls to level commensurate with full-employment in many sectors of the economy wages start to lift more rapidly.
The current unemployment rate sitting around 5% nationally and even less in New South Wales and Victoria is low enough to generate pockets of skill shortage but is not low enough to be consistent with general labour shortages capable of driving up wages more rapidly.
It is also fair to say that if the current unemployment rate were to drift upwards what slow upward pressure on wages that currently exists would falter. In turn, the prospects for growth in household income and spending would turn softer and annual inflation would likely be lower than forecast currently.
The RBA’s current set of economic forecasts as shown in the quarterly Monetary Policy Statement published last week sit close to the boundary where an already growth accommodating monetary policy setting may need to be made more growth accommodating. That boundary, however, has not been crossed just yet. Forecast growth lifting to 2.75% in 2020 and inflation to 2.0% do not yet dictate the need for a cash rate cut.
The low unemployment rate is the key element supporting the forecast lift in GDP growth and inflation in 2020. The unemployment rate must hold close to 5% over the next few months and by later this year start to edge lower to support the RBA’s forecasts and our contention that the cash rate will stay at 1.50% this year extending in to 2020.
The summary of the latest quarterly Monetary Policy Statement concluded,
“At its recent meeting, the Board focused on the implication of low inflation outcomes for the economic outlook. It concluded that the ongoing subdued rate of inflation suggests that a lower rate of unemployment is achievable while also having inflation consistent with the target. Given this assessment, the Board will be paying close attention to developments in the labour market at its upcoming meetings”.
That seems to say it all. Developments in the labour market will determine whether the RBA needs to lower the cash rate further. If the labour market starts to show signs of weakness relative to the RBA’s latest forecasts (wages slowly edging up; unemployment rate steady near-term; lower medium-term) the RBA will cut the cash rate. If the labour market holds firm along the lines the RBA and we are forecasting, the cash rate will stay on hold at 1.50%.