Slowing for Now

Australian economic growth and inflation have been moderating since early-to-mid 2023 and the call is growing louder (unwarranted in our view) for the Government and the RBA to take policy action to stem and reverse the tide. According to the latest quarterly (Q4 2023) reports for growth and inflation annual real GDP growth has decelerated to 1.5% y-o-y from 2.4% a year earlier in Q4 2022, while CPI inflation was down to 4.1% y-o-y from a peak of 7.8% y-o-y in Q4 2022.

The slowing economic growth rate has been one, but not the only contributor bringing inflation down. Overseas economic factors have been the most significant factor bringing inflation down and that shows in the tradeable and non-tradeable components of the CPI.

Tradeable inflation, or that part of Australia’s inflation rate attributable to movements in goods and prices sourced overseas, fell from 8.7% y-o-y in Q4 2022 to 1.5% y-o-y in Q4 2023, whereas non-tradeable inflation relating to home-grown price pressure fell from 7.4% y-o-y in Q4 2022 to 5.4% y-o-y in Q4 2023.

Australian domestic or tradeable inflation has fallen under pressure from weakening economic growth but was still far too high in Q4 2023, relative to the RBA’s 2-3% inflation target and even if weak or weaker economic growth continues placing more downward pressure on domestic inflation through the first half of 2024 further assistance will be needed from softer overseas inflation to get Australian CPI inflation down closer to the RBA’s target any time soon.

Another quarter or two of weak economic growth will be needed to bring domestic inflation down from above 5% y-o-y to around 4%, a level that together with low international inflation pressure will put CPI inflation in sight of 3% y-o-y by the end of 2024 and inside 2-3% target band by the second half of 2025. The policy mix – tight monetary policy and a neutral government budget position – that has generated soft economic growth needs to be maintained through much of this year to provide greater certainty that the RBA will get inflation down within target and keep it there.

One part of the policy mix, the neutral (small underlying government budget surplus) position has been only partly by design. The Federal government has been spending more in real terms, but the spending has been offset by a higher tax take mostly higher-than-expected commodity prices driving higher company tax receipts but also a higher personal tax take because of strong employment growth, higher wage growth and the removal of the low-and-middle income tax rebate back in July 2023. The Federal Government’s budget position will move towards promoting growth in 2023-24 when the revamped stage 3 personal income tax cuts come into play.

The Government is also indicating that the focus of the 2023-24 Budget will shift away from containing inflation towards dealing with weak growth and providing more cost-of-living compensation. In short, net government spending will show noticeably more positive real growth in 2023-24 than in 2022-23, supporting stronger economic growth and potentially underpinning domestic inflation.

With a growth-priming government policy change in prospect, the RBA would need to be convinced that the weak economic growth evident through the second half of 2023 will persist or be even weaker through the first half of 2024, if it is to start cutting the cash rate in the second half of 2024. A combination of growth priming fiscal and monetary policy, if it occurs later this year, would prime inflation later in 2025 and in 2026. That will be a risk worth taking if the inflation pulse is very weak later this year, but if inflation has been scotched but not beaten, RBA interest rate cuts later this year would promote too strong revival of growth and domestic inflation would reaccelerate later in 2025 and in 2026 requiring a new round of interest rate hikes.

The stakes are high surrounding when the RBA may be able to start cutting the cash rate. Potentially reducing the risk around starting to cut the cash rate in the second half of this year economic growth has slowed and with weakening support from household spending. Weaker growth is feeding softer labour market conditions lifting the unemployment rate which in turn may help to cap too-high wage growth. Abysmal labour productivity (real GDP per hour worked) through the early 2020s has also taken a positive turn in the second half of 2023, up 1.0% q-o-q in Q3 and up 0.5% q-o-q in Q4 taking annual change to -0.4% y-o-y in Q4.

Adding to the risk of starting to cut the cash rate later this year are that the worst of the factors are over containing household spending growth, including negative real wage growth, higher net interest payment burden and higher taxation. Real wage growth has turned positive, net interest payment burden is peaking and taxation burden will ease sharply from July. Negative growth in real household disposable income is turning to growth. There is a material risk that the economic growth slowing for now but may not continue to slow and could pick up pace without any assistance from easing policies.

At the very least, the RBA will need more information about growth, the labour market, wage growth, inflation and government policy intentions before it is able to assess the extent of the risk it will be taking by starting to cut interest rates. Our view about when the RBA may be able to start cutting the cash rate remains November or December this year at earliest.