Labour Market Tipping Point

Two key data points released last week say that Australia’s labour market may have reached a tipping point. The labour market may be taking a softer turn and that could remove pressure on the RBA to hike rates any further in this cycle. At the very least, if there are any more rate hikes to come, they will not occur until November or after.

The key data released last week were the Q2 wage price index and the July labour force report. The wage price index rose by a lower-than-expected 0.8% q-o-q in Q2 taking annual wage growth down one notch to 3.6% y-o-y from 3.7% in Q1.

Wage growth will lift in Q3 and Q4 reflecting various large wage increases that took effect from July 1^st, including the minimum wage increase and the big rise for age care workers. Also, several multi-year enterprise bargaining agreements have been agreed recently with 4%+ wage increases in the first year. Wage growth is still on a trajectory to push above 4% from later this year but is unlikely to push much above 4%.

Wage growth below 4% y-o-y on the latest Q2 wage price index and topping out just above 4% over the next year adds some muscle to the RBA’s latest indication that there is a credible path for inflation to return to 2-3% target by late 2025. It is still important that annual wage growth does top out a little above 4% and that is where the second key data report from last week comes into play, the July employment fall causing the unemployment rate to rise to 3.7%.

Employment fell by 14,600 in July against expectations of a 15,000 increase. That is not a big miss in the scheme of things, and we really need in the August data (due mid-September) either a very small rise, or a fall in employment to confirm that the labour market has taken a softer turn. Also, it is important that the unemployment rate that lifted 0.2 percentage points in July does not reverse direction.

There are reasons why the labour market could have taken a genuinely softer turn in July. Retail sales have been weakening since mid-2022 and some retail stores have started cutting back their workforce. There has also been talk of staff cutbacks in banking and finance and the tech sector.

Set against these sectors of the economy experiencing some staffing cuts there are still staff shortages in big employing sectors in education, health and other services, but these shortages may be becoming less acute with the big lift in immigration over the past year or so. Labour supply has improved substantially with net migration running close to 400,000 a year since early-2022.

However, the key reason why the labour market may be softening is that it responds with a lag to softening growth in aggregate demand which in turn has softened with a lag in the wake of higher interest rates. It is a fair bet that the labour market may be showing a lagged response in July 2023 to the RBA’s interest rate hikes delivered between May 2022 and February 2023.

The lagged response to rate hikes to February this year still has further to run. The full impact of rate hikes can take 15 months, or more. That also means that the impact of the rate hikes since February on the labour market are still to be felt and will continue to impact through to late 2024.

While there is reason to believe that labour market conditions may have started to soften in July, the RBA will need to see more data over the next month or two to confirm that labour market conditions are softening. During that period, it is unlikely that the RBA will find cause to hike rates further.

Labour market conditions would need to take a materially stronger turn in August and September together with some evidence that inflation is proving stickier than expected if the RBA is to return to hiking rates in November and beyond.

Our earlier forecast that there could be one or two more rate hikes left in this cycle seems less likely after the Q2 wage and July labour market reports. We will wait until the August labour force report before deciding whether to adjust our forecasts, but if the August report is soft, we will change our rate call to the peak has been reached at 4.10%.

Peak is perhaps an inappropriate word to describe the top of the current interest rate cycle, plateau might be better. What is increasingly apparent is that even with softening labour market conditions, annual wage growth will stay near 4% y-o-y for at least the next two years. Absent a remarkable lift in labour productivity that will make returning inflation to target a slow affair.

Another factor coming into view and slowing progress getting inflation down is the depreciating Australian dollar. If the Australian cash rate has peaked at 4.10%, that is more than a percentage point below the peak in the US (already at 5.50% with some indication from the Fed it could rise higher). The interest rate differential is counting against the Australian dollar.

Also, the lower outlook for commodity prices and Australia’s terms of trade is counting against the Australian dollar. It is a fair bet that Australian dollar depreciation has some way to go and will contribute to higher Australian import prices.

So, while it is possible that the cash rate may not go any higher than 4.10% because of the arrival of the labour market tipping point, there are factors that will prevent any early reduction of the cash rate. We see the RBA needing to hold the peak cash rate (possibly 4.10%) through to at least the second half of 2024.