The main reason why the RBA is toying with the idea of cutting the record low 1.00% cash rate even more is that annual wages growth remains low and according to the RBA’s latest set of forecasts is likely to stay low for the next two years. Low wages growth in turn anchors annual inflation below the bottom end of the RBA’s 2-3% inflation target range through to the end of 2020 at least. A lower cash rate is not a response to an economic growth rate that is weakening. The RBA is forecasting the opposite and that annual GDP growth rate will lift from around 1.7% y-o-y currently to 3.0% by mid-2021, but rather an attempt to allow the labour resources in the economy to be more fully utilised.
The economy is generating strong demand for labour and good employment growth but the supply of labour has been growing unusually strongly over the past two years. The labour force participation rate has lifted over that period from 65.1% to a record high 66.0% (male participation rate up from 70.5% to 71.3% and female participation rate up from 59.8% to 60.9%). The lift in labour force participation is a sign that people are confident about finding work. It also a sign that the labour market is flexible providing more labour supply when needed. The downside is that there has been little pressure on employers to offer higher wages, other than in isolated pockets where specifically skilled labour has been in short-supply.
Apart from annual wages growth stuck in a slow growth groove (the Q2 wage price index is due this week and is expected to show annual wages growth at 2.3% y-o-y, the same as the reading in Q1) another marker that supply and demand for labour are just about in balance is the unemployment rate stuck at 5.2% over recent months.
According to the RBA’s latest economic forecasts released in the quarterly Monetary Policy Statement last week it expects supply and demand for labour to stay in balance with annual wages growth to stay at 2.3% y-o-y over the next 18 months and the unemployment rate to be steady around 5.2%. This forecast of no change in general labour market conditions is unusual given that the RBA is forecasting improving GDP growth over the same period that should give greater lift to demand for labour.
One explanation is that the RBA expects the unusually strong lift in the labour force participation rate that has occurred over the past two years to be at least as strong again over the forecast period continuing to generate strong growth in supply of labour. While it is possible that the labour force participation rate continues to rise, it seems more likely that the pace of growth in the participation rate will moderate as the number of people lessen in the various pools of potential entrants considering the move to enter or re-enter the workforce.
If GDP growth slowly improves as the RBA is forecasting, we suspect that demand for labour will run stronger than supply slowly lowering the unemployment rate and causing annual wages growth to slowly increase. Our forecasts imply little pressure on the RBA to lower the cash rate any further.
The test will be what happens to the unemployment rate and wages growth over the remainder of this year and early in 2020. If the unemployment rate falls a little and annual wages growth edges up, as we expect, there will be little pressure on the RBA to reduce the cash rate below the current 1.00%. Even if the RBA’s current economic forecasts are closer to the mark and the unemployment rate is still at 5.2% in six months and wages growth still at 2.3%, the RBA is unlikely to cut further.
However, if the unemployment rate rises from the current 5.2% and wages growth slides lower than 2.3% y-o-y, the RBA is likely to cut the cash rate further. Needless to say, the Q2 wages report and the July labour force report later this week are both important readings set against the RBA’s forecasts and could influence what the RBA does next with the cash rate.