The RBA paused at its April policy meeting after ten consecutive interest rate hikes that cumulatively lifted the official cash...
The RBA paused at its April policy meeting after ten consecutive interest rate hikes that cumulatively lifted the official cash rate 350 basis points from 0.10% in April 2022 to 3.60% set at the early-March 2023 policy meeting. The questions after the April 2023 decision to pause are how long will the pause last and beyond is the next rate move another rate hike or a cut?
Economic data readings over the next month could help to answer these questions, although we suspect they may prove to be inconclusive about the likely strength of demand and inflation in the months ahead. In short, they may influence the RBA to pause longer before making its next rate decision.
At this stage, the RBA is forecasting that the reduction in growth in household demand will continue promoting a slow decline in inflation taking it back to 2-3% target range by mid-2025. If incoming data supports the RBA’s view there is not much need for the RBA to hike interest rates much higher than where they stand currently. The problem, however, is that there is a great deal of uncertainty around its forecast of slowing household demand and inflation with identifiable forces pulling in opposite directions.
Household demand growth is subject to opposing factors. One important influence that on balance is causing household demand growth to slow is the sharp rise in borrowing interest rates over the past year. This negatively affects the 35% of households with a home mortgage in particular. The spending of this group is likely to continue to moderate even allowing for forces pulling in the opposite direction on household spending - high employment, low unemployment (near 50-year low) and under-employment (near 30-year low) supporting strong income growth.
In addition, another potential positive factor influencing household spending growth is a still large savings buffer built up from government support payments and inability to spend during the long pandemic lockdown phase. This savings buffer, however, is unevenly distributed and is relatively small among the home mortgage paying cohort of the population.
Another 35% of households rent their homes, and the unusually big increases in housing rent over the past year is cutting hard in to their budgets and ability to spend. The rise in housing rent is a two-edged sword as far as inflation is concerned potentially reducing household spending taking some pressure off inflation while directly adding to the CPI through the housing rent component of the index. Housing rent has a 6% weighting in the CPI.
Housing rents look set to continue to rise at fast pace for at least the next year or two. Supply of rental homes has fallen well below demand and the gap is widening with supply of new homes falling partly because of big increases in home building costs challenging builders offering fixed price new home packages. In addition, a marked reduction in average household size to around 2.5 persons per home in the wake of the pandemic is further stretching limited housing supply.
On the housing demand-side the big boost now and over the next year or two is the sharp lift in immigration expected to lift Australian population growth from near zero during the pandemic restrictions to a booming 2% a year. This big immigration lift will not only add to the housing rental crisis directly adding to inflation through the housing rental component, but it will also boost growth in household spending countering other factors working towards slowing growth in household spending.
The stickiness of high housing inflation slowing progress reducing overall inflation means that the RBA cannot allow other inflation factors to gain traction. It needs household spending growth to continue to slow. Monthly retail sales readings will be key indicators. They need to soften further.
The state of the labour market will be important too. Annual wage growth at just above 3% y-o-y according to the Q4 2022 wage price index is consistent with inflation coming down to 2-3% target over time. If annual wage growth accelerates quickly above 4% it starts to become inconsistent with achieving the inflation target.
Currently, the very low unemployment and under-employment rates if sustained are likely to push wage growth well above 4%. It is important to the RBA that labour market conditions soften over the next year. That means the unemployment rate pushing above 4% for a period, although the RBA will still be keen to avoid the unemployment rate pushing up too far.
The RBA will be monitoring closely many factors over the next month or two to try and gauge whether it is on track to achieve 2-3% inflation by mid-2025. We cannot see that the outlook will be clear enough on the data to be released – another month or two of retail sales, labour market readings, business and consumer sentiment – for the RBA to be comfortable enough to declare that it has hiked the cash rate enough for this cycle. It is in a position, however, to continue monitoring indicators for at least another month or two before deciding whether it needs to hike rates further.
What is not in the mix at this stage is any case for the RBA to consider a rate cut. The case for a rate cut would need at the very least a sharp lift in the unemployment rate well above 4% and a string of monthly very weak retail sales numbers.
The RBA has warned that some market forecasts looking for a cut in the cash rate later this year are wide of the mark. More likely the cash rate will need to be at the current 3.60%, or higher for many months.
Our latest forecast provided with no great confidence given the many conflicting forces influencing the outlook for household spending and inflation is that the cash rate stays on hold at 3.60% through the remainder of this year extending to Q2 2024 before a cut.