The RBA’s November Statement on Monetary Policy upgrades the inflation and growth forecasts even with a higher assumed path for interest rates. How this can coexist with an unusually large fall in household sector real incomes remains to be seen. Risks to the inflation forecast are also skewed to the upside. If things turn out in line with the RBA’s revised forecasts, they might not need to raise rates again. But the bar to further hikes is clearly lower now; the RBA has almost no margin for further upside surprises.
The RBA’s Statement on Monetary Policy elaborates on the reasoning behind this week’s decision to raise the cash rate. Underlying inflation has not declined as fast as the RBA expected a year ago or three months ago. The inflation forecasts have been revised up and most of the risks are to the upside, including domestic services inflation, rising medium-term inflation expectations and weak productivity boosting growth in effective labour costs. The RBA highlighted their concerns about the higher inflation outlook by adding a graph showing both current and August forecasts for trimmed mean inflation in addition to the usual forecast-with-uncertainty-bands graph.
The RBA has been surprised by the resilience of domestic demand, especially outside the household sector; this is another factor that will tend to lift inflation. Near-term GDP growth is now expected to be stronger, with some of the resilience of business investment seen in the first half of 2023 carrying over into the second half. Our own forecasts embed a view that much of this first-half strength in equipment spending was a pull-forward to take advantage of tax breaks, which will not be repeated in the second half. Likewise, some of the strength was a catch-up as supply chain disruptions dissipated, a process that will come to an end at some point. On the other hand, more investment is needed to restore the ratio of capital to labour to earlier trends, and so support the needed improvement in productivity.
As flagged in the Governor’s decision statement, the unemployment rate profile has also been revised down. It might be that the RBA is expecting more of the softening in labour market conditions to come through underemployment than previously thought. The labour market has clearly turned, though it remains tight; the SMP points to a range of indicators in support of this assessment, including youth and medium-term unemployment, as well as underemployment.
These upside revisions to the forecast have occurred despite a roughly ¼ percentage point higher assumed profile for the cash rate, based on market pricing and private sector forecasts. The peak is around 4½%, which does not imply that further increases after November’s are baked in.
Central to these changes is the upward revision to assumed population growth. Both GDP growth and employment growth are about ½ percentage point higher in the forecast for 2024 than in the RBA’s August forecasts. Because the extra population adds to both supply and demand, the effect on unemployment and (non-housing) inflation is marginal at best. There is, however, a significant effect on the housing market. The SMP text calls out the strong growth in rents, rising housing prices and increases in average household size in the major cities as being connected to this dynamic.
Despite the forecast upgrades, GDP growth is expected to remain slow. The household sector is being squeezed by the higher cost of living, rising tax take and, increasingly, the effect of higher interest rates. The consumption forecasts for 2024 were revised down noticeably (–0.3%points), with no growth payback in 2025. Given the higher population assumption, this is a material downgrade on a per person basis. It also aligns with what we are seeing in our Card Tracker data (see Westpac Senior Economist Matt Hassan’s report earlier today).
The RBA notes that falling real household incomes are driving the weakness in consumer spending. The Bank’s real household disposable income forecast for year to June quarter 2024 has been revised down 1½ percentage points to –1.1%. Such is the weakness in the income forecasts that even the current weak consumption forecasts can only be sustained with a near-zero household saving ratio in the first half of 2024.
It is hard to conceive how such an extended period of declining real incomes – even worse in per household terms – can coexist with a still-tight labour market. It is also a little hard to square the still-tight labour market and cost of living squeeze with the downward revision to the forecast path for wages growth and (in 2024) average earnings. While the forecast bounce-back in household incomes is also a bit sharper, the experience of the Australian household sector will stand in contrast to its counterparts overseas.
Most of the other changes speak to increasing concerns that inflation will not come down as quickly as the Board intends. The language around weak productivity growth continues to highlight inflation risks. The SMP overview states, “the forecasts assume that productivity growth will pick up, which will be needed for labour cost growth to be consistent with the inflation target”. In August, the assumption was that productivity growth would return to pre-pandemic trends. The SMP text calls this out as being a particular issue for services inflation, which embeds a larger share of labour costs than do goods prices. Another important change in language in the SMP overview is the recognition that some measures of medium-term inflation expectations have risen a little lately.
Because services inflation has been so sticky, the RBA is also sceptical that disinflation abroad is assured. It believes that ‘[t]he risk that inflation takes even longer to return to target has increased.’ On the other hand, the risks to global growth were held to be tilted to the downside. We agree, but there is a tension in how these risks sit together.
The Board considered both the case to hold and the case to increase rates at the November meeting. As we expected, the case to raise rates was stronger. The chance that the Board will need to do more, presumably in February, is also rising. The refreshed forecasts embed very little margin for upside surprises on inflation.
