In two weeks, the RBA holds its August interest rate setting meeting and there is an active debate about whether the RBA will...
In two weeks, the RBA holds its August interest rate setting meeting and there is an active debate about whether the RBA will leave the cash rate unchanged at 4.35% or will hike 25bps to 4.60%. Our view is that the bar is set very high for the RBA to consider another rate hike. Even though data out next week is likely to show that inflation is running higher than the RBA would like we doubt whether that will force the RBA to hike. It is where inflation is likely to travel over the next 12 months or so that will inform the RBA’s rate decision in August and the committee will have to hand the RBA’s latest economic forecasts contained in the quarterly Monetary Policy Statement (MPS).
There is little doubt that the Q2 CPI when it is released on Wednesday week (31st July) will show annual headline inflation lifting from 3.6% y-o-y to closer to 4.0%. The RBA was expecting some lift in annual inflation mid-2024 and stickiness in the second half of 2024 when it released its last set of economic forecasts back in May. At that time, the RBA forecast that CPI inflation would lift from 3.6% y-o-y in Q1 2024 to 3.8% in Q2 and then hold around 3.8% before moderating through 2025 to 2.8% by year-end. With that forecast inflation trajectory the RBA has discussed at the last two interest rate setting meetings whether it should hike further but has settled for leaving the cash rate on hold.
The key reason why the RBA stayed on hold was its belief that inflation would track lower next year towards target notwithstanding evidence of higher current and near-term inflation. The RBA felt that interest rates were high enough to limit growth in demand in the economy and bring it closer in line with supply in the economy. With a lag that would lower inflation, even from a temporarily higher rate than forecast previously.
The degree to which the RBA can be confident that the current higher-than-expected inflation blip is temporary is governed by whether demand growth is subdued enough. Softer demand growth generates with a lag a rise in unemployed resources which in turn with a further lag reduces inflation. If the RBA has evidence of moderating growth in demand it can expect with some confidence a lagged moderation in inflation.
Back in May, the RBA forecast that GDP growth would moderate from 1.5% y-o-y in Q4 2023 to 1.2 y-o-y in Q2 2024 before slight improvement to a still relatively weak 1.6% y-o-y in Q4 2024. A year of sub-par growth in 2024 would in turn cause the unemployment rate to lift in the RBA’s forecasts from 3.9% in Q4 2023, to 4.0% in Q2 2024 and 4.2% in Q4 2024. This moderation in GDP growth and lift in the unemployment rate would set the conditions for inflation to moderate in 2025.
Essentially, if GDP growth and the unemployment rate are tracking in line or softer than the RBA’s forecasts this year it still has good cause to forecast moderating inflation next year.
Taking GDP growth first, over the most recent three quarters through to Q1 2024, the quarterly change has tracked between 0.1% q-o-q and 0.3% averaging only 0.2%. In the latest GDP report for Q1 2024 the rise was 0.1% q-o-q, 1.1% y-o-y. To make the RBA’s May MPS forecast for Q2 2024 GDP growth of 1.2% y-o-y a 0.3% q-o-q GDP reading is needed, but recent economic readings seem to point to 0.2% or less. The Q2 2024 GDP reading due in early September seems to be tracking softer than the RBA’s May MPS forecast and implies that the RBA’s August MPS may revise forecast GDP growth down from the May forecasts for the remainder of 2024.
There is still an issue of whether the July 1st tax cuts will boost demand and GDP growth in the second half of this year, but surveys are indicating that in an increasingly uncertain economic environment the tax cuts will be mostly saved or used to retire expensive debt rather than spent.
Turning to the unemployment rate, that too is tracking slightly softer than the RBA’s May MPS forecast of 4.0% average in Q2 2024 – the actual was nearer to 4.1%. The softer track of GDP growth than previously forecast by the RBA implies that the unemployment rate will rise more through the remainder of 2024 than the RBA was forecasting back in May. Wage growth at 3.9% y-o-y in Q1 2024 also appears to be tracking softer than the RBA was forecasting back in May when they had the Q2 2024 wage price index up 4.2% y-o-y in Q2 2024.
When the RBA delivers its latest economic forecasts in the August MPS any tweaks to the GDP growth, unemployment rate and wage growth forecasts must be softer for Q2 and Q4 2024 relative to the forecasts produced in the May MPS. The May MPS forecasts of GDP growth, unemployment rate and wage growth in 2024 were compatible with inflation moderating back towards target 2-3% range by late-2025 and meant that near-term higher-than-expected inflation results while worrying did not prompt a rate hike.
The bar for a rate hike is set even higher if as we suspect the RBA tweaks slightly softer forecasts of GDP growth, the unemployment rate and wage growth in the August MPS. The RBA can be more confident that the inflation rate will moderate in 2025.
Our view is that the August RBA interest rate setting meeting will leave the cash rate unchanged at 4.35% and the decision will be ratified by a tweak softer in several economic forecasts in the August MPS that will allow the RBA to maintain its May MPS moderating inflation forecasts for 2025 and the first half of 2026 even in the face of a relatively high Q2 2024 CPI report. It is worth keeping in mind that those inflation forecasts while limiting any need to hike the cash rate do imply that the cash rate needs to be held at the current 4.35% through to at least mid-2025, with only limited scope for cuts beyond.