Slow Enough

Has the RBA braked hard enough to deliver slow enough growth to deliver annual inflation back inside 2-3% target band over the next 2-3 years? The question comes with a couple of tweaks – braked hard enough with the addition of one or two more rate hikes and slow enough growth without tipping the economy in to recession. It will be a very hard monetary policy delivery act to get just right.

The RBA’s latest set of economic forecasts released in the August quarterly Monetary Policy Statement show the RBA getting policy delivery just right with annual GDP growth after a small blip higher from 3.3% y-o-y in Q1 2022 to 3.5% in Q2 moderating beyond to 3.2% in Q4 2022, 1.8% in Q4 2023 and 1.7% in Q4 2024.

With the forecast moderation in growth and with a lag tightness in the labour market dissipates slowly. Annual growth in employment at 3.3% y-o-y in the latest June labour force report accelerates to 4.4% in December 2022 before slipping through 2023 and 2024 to respectively 1.4% and 0.9%. In turn, the unemployment rate at 3.5% in June falls to 3.4% in December 2022 before lifting through 2023 and 2024 to respectively 3.5% and 4.0%.

The forecast slow reduction in tight labour market conditions flows to forecast annual wage growth at 2.4% y-o-y in the latest Q1 2022 report, lifting to 3.0% in in December 2022, 3.6% in December 2023 and 3.9% in December 2024. Wage growth slow to lift so far, once it gets moving will be slow to cap out and start to reduce.

The RBA’s latest forecasts show annual CPI inflation increasing from the current 6.1% y-o-y in Q2 2022 to 7.8% in Q4 this year and then reducing to 4.3% in Q4 2023 before falling to the top end of target band at 3.0% in Q4 2024. Underlying annual inflation (trimmed mean) rises from 4.9% currently to a peak 6.0% in Q4 2022 before receding to 3.8% in Q4 2023 and 3.0% in Q4 2024.

These latest RBA forecasts include a number of assumptions including “a path for the cash rate broadly in line with expectations derived from surveys of professional economists and financial market pricing” – around 3.00% peak cash rate late 2022/early 2023 at the time the RBA produced the forecasts.

On the RBA’s latest forecasts the Australian economy slows, but just avoids recession getting away with a modest lift in the unemployment rate over the next two years or so with inflation back inside target band in 2025 and all for lifting the cash rate relatively promptly to 3.00%. What could go wrong?

The answer is quite a lot could go wrong, as it has repeatedly with every quarterly set of RBA forecasts over the past year, as well as everybody else’s forecasts to be fair. The various supply side shocks related to covid spread and shut downs as well as war and climate disruption have been unpredictable and may still have further unpredictable twists and turns ahead.

The strength of demand has proven hard to forecast. Government largesse during the covid shutdowns has helped to boost household savings (the Australian household savings ratio was above 11% in Q1 2022 still about three times its long-term average) and a war chest for catch-up spending by consumers now turning their sights towards spending on services rather than the initial splurge on goods during and just after shutdown periods.

Catch-up spending has caught businesses on the hop, needing in many cases to boost their workforces quickly from a pool of available workers depleted by a two-year absence of overseas workers that is only slowly ramping up. Service industries need to employ more people than goods producing industries. The unemployment rate is still falling rapidly and already before the ink is dry on the RBA’s latest August forecasts it seems likely that in the next few months the unemployment rate will dive below the 3.4% RBA forecast for Q4 2022.

That is not the only RBA forecast at risk before the ink is dry. The RBA forecasts that Q2 GDP out early next month will lift to 3.5% y-o-y from 3.3% in Q1. The RBA’s forecast implies a quarter-on-quarter lift in GDP around 1.0%, but two pieces of data released last week after the the RBA completed its forecasts indicate GDP rising more than 1.0% q-o-q in Q2.

Retail spending lifted in Q2 by 1.4% q-o-q in real terms. Household consumption spending could contribute around 0.8 percentage points to Q2 GDP. Australia’s June international trade showed a much bigger-than-expected surplus of $A17.67 billion and cumulatively the trade surplus for the three months to June was more than $A18 billion greater than the three months to March. The real change after deflating for the changes in export and import prices is much less, but still of the order of $8 billion implying a net export contribution of 1.5 percentage points to GDP.

Other contributors to Q2 GDP could contribute negatively, but the size of the household consumption expenditure and net export contribution look set to lift q-o-q GDP closer to 1.5% rather than the RBA’s 1.0% forecast.

So far, the identifiable pressure appears to be on the upside for the RBA’s near-term growth and employment forecasts seemingly implying upside to their wage and inflation forecasts and the need for more than one or two rate hikes and perhaps a peak cash rate north of 3.00%.

However, there are circumstances that could turn this upside risk to the cash rate outlook on its head. Fear of weaker economic growth ahead plus perhaps quicker resolution of supply chain blockages than expected currently could see key commodity prices tumble, including energy and food prices. CPI inflation could peak earlier and lower than the RBA is forecasting and slide further than forecast next year.

Also moving from an extremely low interest rate regime relatively quickly and now promising a prompt return to “more normal” interest rates at a time when the household sector has accumulated high levels of debt that look far from normal other than in a scenario of continuing low interest rates, risks an unusually sharp cut back in activity in the most interest rate sensitive parts of the economy such as housing. The RBA may have already braked hard enough to tip the economy close to recession in 2023 and the next one or two rate hikes could push the economy over the edge.

The economic outlook has become much trickier. Still strong economic readings over the next few months (stronger than their August forecasts) could push the RBA to hike more. Yet the next rate hike or two could be the straw that breaks the camel’s back tipping the economy in to housing-led recession.