Analogies abound as the RBA Governor and the Federal Treasurer try to explain Australia’s economic outlook given current economic...
Analogies abound as the RBA Governor and the Federal Treasurer try to explain Australia’s economic outlook given current economic policy settings. The narrowing path to getting inflation down sustainably within 2-3% range is a popular analogy at the RBA, while the Federal Treasurer has embellished that recently to ‘a soft landing on a narrow runway’.
Essentially, the RBA Governor and the Federal Treasurer are both indicating the difficulty of Australia avoiding recession and achieving only a small rise in the unemployment rate (a peak unemployment rate with a 4 on the front) and inflation, both headline CPI and underlying, sitting under 3%.
It is worth considering what has made the soft-landing path or runway so narrow and why it seems to be getting narrower – we believe it is almost non-existent. Encroaching on one side of the path is inflation, sitting stubbornly above 3%, while on the other side of the path is a nasty ditch of falling GDP and rapidly rising unemployment.
The RBA and the Government between them need to run a set of policies that avoid widening the recession/high unemployment ditch while not adding to the encroachment of unacceptably high inflation.
Despite our skepticism, there are still some signs that Australia may achieve a soft landing. GDP is still growing, up 0.1% q-o-q, 1.1% y-o-y in Q1 2024 and with more employment growth (up 344,900 over the past year, or 2.5% y-o-y) and a lower unemployment rate (4.0% in May) than might normally be expected with soft economic growth. But the relatively good news about economic growth and the labour market needs to be tempered by signs that, while inflation is lower than it was, progress has stalled, at least as far as the monthly CPI readings are concerned, with annual inflation rising from 3.4% y-o-y in February to 3.5% in March and 3.6% in April.
The RBA is determined that sticky inflation does not encroach on or completely grow over the soft-landing path. The only tool it has in its arsenal to combat inflation is high interest rates that work by suppressing excess demand. The effect of high interest rates on demand is uneven. The younger, higher borrowing cohort of the population are hit quite hard, whereas the older and high saving cohort may benefit from high interest rates.
Raising the cash rate over the past two years from 0.10% to 4.35% has slowed demand in the economy, notably household consumption spending growth, although there is a hint in the Q1 GDP report that growth in household spending was firmer through 2023 than reported previously and may be starting to accelerate. A potential rekindling of growth in household spending, albeit from a low level, might be regarded as too soon by the RBA given that inflation is still well above 3% with signs of faltering deceleration.
The RBA cannot risk adding to the nascent recovery in demand by starting to lower the cash rate, or even hinting that a rate cut may not be far away. At the RBA’s interest rate setting meeting tomorrow it is almost certain that the RBA will leave the cash rate unchanged at 4.35% and will repeat that it will not hesitate to lift rates further if inflation stays sticky or starts to rise.
Another reason why the RBA is becoming more worried about the sticky inflation version of the soft-landing path rather than the falling growth/high unemployment ditch on the other side is that Federal and State Government economic policies are leaning towards boosting demand, economic growth and inflation.
Federal and State Treasurers will undoubtedly disagree that they are boosting inflation, claiming various cost-of-living measures in their budgets that will work to lower some prices. If those cost-of-living measures were fully funded in their budgets i.e. without any impact on net government spending, they might have a case that they are helping to lower inflation. The budgets brought down so far have all included material increases in net government spending, adding to total demand and inflation pressure in the economy.
Also, the cost-of-living measures are adding to what is likely to be a large rise in household disposable income in 2024-25, brought about by real wage growth (wages look like growing at least 4% y-o-y, with the Federal Government still a cheerleader for real wage growth) and substantial income tax cuts. Households may choose to save rather than spend the lift in household disposable income, an outcome which would keep the narrow path to a soft landing open.
However, it is also worth noting that household wealth has risen sharply over the past year helped by higher prices of houses and financial assets. The combination of higher household wealth as well as the approach of higher household disposable income looks much more likely to prime household spending rather than saving.
In short, we see the narrow path to a soft economic landing becoming even narrower due to an expanding demand-driven sticky inflation verge. That implies little or no opportunity for the RBA to start cutting interest rates until mid-2025 and a growing risk that when the cuts come, they are limited and possibly short-lived.
The Treasurer’s economic aircraft does not look to be attempting a landing. Instead, it is taking on more fuel, gaining altitude and risking pumping out more inflation and delaying when the RBA can start easing its foot on the air brakes.