US and Australian economic prospects are diverging and that may require the Federal Reserve (Fed) and RBA to deliver different official interest rate outcomes. To some extent, this has already occurred with the Fed having pushed its funds rate up to 4.75% and still needing to decide whether it should push ahead with a 50bps hike rather than a 25bps hike at the policy meeting next week, whereas the RBA with the cash rate at 3.60% after the 25bps hike at its policy meeting last week can consider at its next policy meeting whether another 25bps hike or an interest rate pause is in order.
Essentially the difference in official interest rate outlook between the US and Australia comes down to clearer evidence of slowing growth in domestic demand in Australia than in the US. The relative difference in domestic demand strength in the two countries is keeping labour market conditions tighter in the US than in Australia and that spells a tougher task for the Fed than the RBA getting inflation down to target and keeping it there.
Growth in household spending provided the mainstay for real US economic growth in both Q3 and Q4 2022 and household spending was continuing to change in favour of spending on services rather than goods. Service industries need a lot of labour and the consequences of strongly growing US spending on services has been rising employment (non-farm payrolls rose by 311,000 in February after rising 504,000 in January). While the US unemployment rate rose to 3.6% in February from 3.4% in January it remains too low to place the downward pressure on annual wage growth still running around 4.5% y-o-y .
In the absence of the US unemployment rising above 4.0%, the Fed faces inflation staying above its 2% target this year, next year and in 2025 as well. That implies more official interest rate hikes over the next few months and when the key US indicators eventually weaken, as they will inevitably under pressure from higher interest rates, the capacity to lower interest rates will be relatively limited by the high risk of re-igniting inflation pressure.
Could this scenario of higher official US interest rates change, with a negative surprise such as the collapse last week of Silicon Valley Bank (SVB), a large regional bank in California providing banking services to many tech companies? Possibly but probably not if the measures taken since the Global Financial Crisis strengthening the capital bases of most US banks plus their more diversified deposit and lending books than SVB’s prove their worth.
Everything that made SVB unusual – concentration on one industry, tech, for its deposits and loans, large proportion in its funding of deposits above the $US250,000 threshold for Federal Deposit Insurance Corporation cover – contributed to success while tech companies prospered, but turned to threat and possible failure as tech companies faced tougher trading conditions and needed to draw down their deposits. In trying to meet unusually high deposit withdrawals SVB needed to sell assets, government bonds trading well below purchase price because of rising interest rates.
The collapse of SVB is likely to add more downward pressure on the US tech sector, part of the US economy that has been weakening against the resilience of other parts of the US economy. The weakness of one sector of the economy and what appears to be an idiosyncratic bank collapse, albeit a relatively big bank, would need to spread to greater concern about US banks and more widespread economic weakness to cause the Fed to change course in its inflation battle. At this stage, US banks look solid and the US economy, even with the weakness in the tech sector, is generating jobs making inflation containment still the major policy priority for the Fed.
In Australia, private demand (household and business spending) is showing clearer signs of slowing than in the US. During 2022 private demand contributed 0.9 percentage points (ppts) to real GDP growth in Q1, 1.0ppts in Q2, 0.7ppts in Q3 and -0.1ppts in Q4. Real household consumption spending growth rose 1.8% q-o-q in Q1, 2.2% in Q2, 1.0% in Q3, and only 0.3% in Q4. Unsurprisingly, Australia with mostly variable interest rate loans and high household debt is proving more sensitive to increases in official interest rates than is the case in the US.
Also in Australia (unlike the US) the slowing in private demand and household consumption growth through 2022 may have prompted some easing of tight labour market conditions. Whereas the US has added 815,000 jobs over the last two monthly non-farm payroll reports, Australia has lost 31,000 jobs over the last two monthly labour force reports. Australia’s February labour force report is out on Thursday and even if it shows jobs lifted 50,000 (as the market expects based on an assumption of an unusually large number of people between jobs in January) it will mean that Australian employment lifted only 20,000 over the last three months. Jobs growth at that pace, or worse, through 2023 would see Australia’s unemployment rate rise well above 4.0% by year end.
The RBA can view the noticeable slowing in private demand and household consumption spending through the second half of 2022 as evidence that demand has been responsive to the first few rate hikes. Moreover, the November, December, February and March rate hikes are likely to have driven demand noticeably weaker again in the early months of 2023. There are signs, even allowing for turn-of-the-year anomalies that the labour market is starting to soften in response to softening demand in the economy. The RBA can be reasonably confident that past price rises will not drive untoward increases in wages and that means that as inflation subsides it is more likely to stay down.
Unlike the US Fed where even a big bank failure is unlikely to override the need to keep hiking official interest rates, the RBA can consider pausing cash rate hikes, and at a comparatively low 3.60%. It is a tale of two different economies, the US economy where demand, the strong labour market and inflation are proving to be sticky in the face of rising official interest rates and the Australian economy proving to be more vulnerable as official interest rates rise.