The Board now believes that the recent data is consistent with achieving the inflation target. It also expresses uncertainty around the link between tight labour markets and inflation. It will be another close call in September but thereafter we expect the weak economy to dominate policy. The first rate cut is not likely until the September quarter 2024.
The Reserve Bank Board left the cash rate unchanged at 4.1% at the August Board meeting.
The key explanation was a desire to take more time to assess the impact of the increase in rates to date and the economic outlook.
The Board also noted that “some further tightening of monetary policy may be required to ensure that inflation returns to target in a reasonable time frame.“
There was a somewhat confusing signal from its assessment of the recent better-than-expected inflation print for the June quarter.
The central forecast for inflation in 2024 held at 3¼ % – unchanged from the May Statement on Monetary Policy, indicating that the June quarter report was not interpreted as signalling a flatter inflation trajectory.
On the other hand, we did see a more confident approach to the outlook for inflation. The Governor’s statement noted that: “The recent data are consistent with inflation returning to the 2–3% target range over the forecast horizon.”
We will see exactly where the staff sees the inflation rate by end 2025 when the Statement on Monetary Policy (SoMP) prints on August 4. The comment in the Governor’s Statement is that inflation will be “back within the 2–3% target range in late 2025.”
With the current forecasts having inflation slowing from 3.2% to 3.0% in the first half of 2025 and the decision statement noting the central case economic growth forecast to be lifting from 1¾ % to 2% (unchanged from the May SoMP) it seems unlikely that the fall into the range will be any more than a further 0.2ppts to 2¾%, indicating that the Board is still comfortable to continue to see inflation holding above the middle of the target range after more than four years above the target range.
While the Statement continued to emphasise the significant uncertainties around the persistence of services inflation it introduced a potentially profound new insight, likely drawn from the experience in the US and other countries, that: “There are also uncertainties regarding the lags in the operation of monetary policy and how firms’ pricing decisions and wages respond to the slowing in the economy at a time when the labour market remains tight.”
This observation may be disclosing that the Board is prepared to entertain the possibility that, due to weak demand, firms are unable to pass on higher costs, including wages, holding down inflation and squeezing margins. This clearly raises questions about the nexus between tight labour markets and rising inflation, possibly explaining why the Board has not responded to the signs of further tightening in labour markets over the last two meetings.
The issues of weak productivity growth; strongly rising unit labour costs, and a margin squeeze continue to get the attention of the Board: “At the aggregate level, wages growth is still consistent with the inflation target, provided that productivity growth picks up.”
They can raise the issue but provide no reason why productivity growth is likely to pick up. The national accounts for the June quarter will print the day after the September Board meeting with likely evidence that unit labour costs continue to rise at a cracking pace – the most recent update having already shown a 7.9% rise over the year to March.
It is unlikely that this issue would have an immediate impact on policy. But, as we argued in last week’s note, it could restrict the progress in bringing down inflation in 2024 – delaying the timing of rate relief.
Westpac expected that the case for another rate increase – based on high services inflation; the 50 year low in the unemployment rate; the clear tightening bias; the unlikely prospect that the staff would lower its inflation or growth forecasts; and only very modest increases in the unemployment rate – was respectable.
In not acting in those circumstances and indicating that “recent data are consistent with inflation returning to the 2–3% target range over the forecast horizon” the balance of risks now favours the prospect that the RBA is now on hold.
It is true that the Board maintains its tightening bias and the volatile monthly inflation indicator could lift sharply in July, just as it did in April. The Wage Price Index could surprise to the high side for the June quarter so we certainly cannot rule another rate hike in September completely out of the picture.
Going into this meeting we assessed that the best approach would be to hike and maintain the tightening bias. As the evidence of the weakening spending continues to build, the case for raising rates becomes progressively more difficult. We were never of the view that rate hikes would extend deep into the second half of 2023 and stand by that approach.
The Board’s assessment of the risks associated with the competing forces of a very weak economy and a very tight labour market appears to be now favouring concerns about the weak economic outlook.
That points to rates remaining on hold
We acknowledge that just as the decision at today’s Board meeting would have been finely-balanced the decision in September will also be close. In October the Board will choose to await the quarterly inflation report and the staff’s updated forecasts. The evidence around the economy by November and the ongoing slowdown in inflation will make a November increase unlikely.
The next challenge for the outlook should now be the timing for the beginning of the easing cycle. When Westpac was forecasting rate hikes in both August and September we were comfortable with the cycle beginning in the June quarter of 2024.
That timing now looks more likely to be in the September quarter 2024 when we expect the unemployment rate to be nearing 5% and inflation in the 3–3.5% range.
Conclusion
The Board is now more confident about achieving its inflation objective of moving into the 2–3% band by end 2025. Not achieving the middle of the target band even by end 2025 seems problematic but the Board seems unfazed about that prospect.
The decision not to raise rates for a second month despite clear evidence of a very tight labour market indicates that the Board will need to see the impact of tight labour markets on inflation. The concept of being pre-emptive seems to have been replaced by a “data dependent” approach to this issue as well.
We do not expect a data flow over the next month that would trigger that hike in September, although the monthly inflation indicator always represents a risk.
Thereafter the weak outlook for activity and the slowing in inflation is likely to preclude any further need for higher rates.
The next move is now likely to be the first cut in the cycle which is forecast for the September quarter of 2024.
