Updated forecasts show stronger than expected economic conditions but potential for upside surprises to see future increases to interest rates.
By Emma Searle
In its November Statement on Monetary Policy, the RBA’s take on economic conditions was stronger than previously forecast. Inflation seems likely to remain higher for longer, alongside historically low unemployment and surprisingly resilient GDP growth.
GDP growth forecasts were brought forward, along with a significant upward revision in year-ended GDP growth for June from 1.5% to 2.1%. The forecast for December of this year included the largest increase from the August forecast, up 0.5% to 1.5%. GDP growth is forecast to recover more swiftly than assumed in August, reaching 2% by the end of 2024, but it is still set to remain below its historical trend over the next few years. Overall, economic growth is expected to be more resilient – rather than weaker as predicted in August – in the near-term, though it will remain at below-trend levels. The same headwinds of high interest rates and cost-of-living pressures as highlighted at the beginning of the year will continue to weigh on the domestic outlook. However, there has been resilience from stronger than anticipated investment (both public and private) and services exports; all considered, this resilience has offset recent weakness in household consumption.
Inflation is forecast to remain higher for longer and only just reach the upper end of the 2-3% target band by the end of 2025. Most of the year-ended inflation forecasts were revised upwards by half a percentage point. CPI inflation is expected to fall to 4.5% in December of this year, with only gradual moderations to 3.5% by the end of 2024 before finally reaching 3% by the end of 2025. This means that the RBA’s hope of meeting its inflation target by the end of 2025 is sitting on a knife’s edge and will be particularly vulnerable to further upside surprises. The November outlook distanced itself slightly from the August headline that “inflation is easing” to emphasise that the pace of the slowdown has been more gradual than initially expected. The upward revisions consider that inflation expectations may rise and remain heightened if inflation doesn’t moderate quickly enough. Services inflation bore the brunt of the blame as poor productivity outcomes drove labour costs, and energy, rent and insurance prices remained elevated.
Resilience in the domestic economy is reinforced by downward revisions to the unemployment rate forecasts by 25% percentage points for the full forecast period. Tightness in the labour market is set to ease moderately, with the unemployment rate rising to 3.75% by the end of the year, before stabilising to 4.25% by the end of 2024 and over 2025. Although there is a stronger upside to employment than in August, underutilisation is the driving force for this gradual easing. Employment is set to grow while average hours worked decreases in response to below-trend economic growth. Increases in the working-age population are forecast to outpace employment, causing the unemployment rate to rise, though it will remain far below historical levels. Historically low underutilisation – particularly in the participation rate – will revert gradually over the next two years, largely driven by increases in underemployment and declining hours worked.
Wages growth is expected to soon reach its peak and then to stabilise at 4% over 2024, before falling in response to easing in the labour market. In the near term, the RBA anticipates strong nominal wages growth due to the tight labour market and persistent inflation growth. Easing in wages is likely to lag behind the slowdown in inflation due to lags in how wages are set and the need for real wages to catch-up. A key risk of nominal wages remaining high is that labour productivity has been consistently weak. Unit labour costs have grown 7% – the highest rate since 1990 – which is due to negligible productivity growth; overall, this adds to the inflationary price-setting pressures for firms.
The November Statement also assumed a higher path of monetary tightening with the peak and end-point of the cash rate now 25 basis points higher at 4.5% by the end of this year or beginning of next year (up from 4.25% in December, as assumed in the August Statement) before falling to 3.5% by the end of 2025 (up from 3.25%). This was unsurprising given the recent hike at the November meeting to 4.35% which ended a 4-month pause in favour of communicating a more hawkish stance with the hope of anchoring inflation expectations.
Trimmed mean inflation – one of the RBA’s preferred measures – was also revised above the levels predicted in August for the entire forecast period, which explains why higher for longer policy rates would be needed. Although, trimmed mean inflation is set to sink below CPI inflation by the end of the forecast period, which implies the RBA expects to have a stronger hold on underlying inflation. Trimmed mean inflation is expected to match levels of CPI inflation of 4.5% and 4% for December 2023 and June 2024, before falling considerably to around 3% from December 2024 onwards.
The RBA identifies uncertainty about the future path of inflation as the key risk to the domestic outlook
If the central bank is unable to tame inflation quickly enough, there is a risk that inflation expectations will become unanchored. The November Statement sets out scenarios which would result in a higher for longer outlook; the risk of persistent inflation considers not only an extended budget strain felt by households, but also the additional cost of higher unemployment as inflation is ushered back to target. Stronger than expected demand, persistent services inflation, supply shocks in energy markets due to the Hamas-Israel conflict, or upsides to rent pricing, are all potential channels for a more stubborn path of inflation.
However, the upside risk to inflation is balanced by risks of burgeoning domestic weakness and shocks to the global economy weighing on export demand and goods prices. This would cause inflation to fall faster than expected and, despite the resulting cost-of-living relief, would indicate a sharp downgrade to growth and activity. An unexpected persistence in weak household consumption would occur if low-income households with low-savings buffers and high levels of debt decrease their spending significantly in response to interest rate hikes. An increased propensity to save among all households due to higher interest rates would further subdue consumption and mean that firms are unable to pass through higher costs.
Additionally, weak growth in China – in particular for real estate investment – alongside restrained policy measures could weigh on commodity demand, export prices, and terms of trade. Consumer confidence in China is also low which may bring downsides to Australia’s currently strong service exports of education and tourism. Global tightening of monetary policy and in financial and credit markets of major economies may pose risks that negative demand responses have become amplified due to the simultaneous tightening. This may lower import prices, which would weigh on domestic goods prices, though this is more likely to be offset by a depreciated in the currency and elevated cost pressures.
Emma Searle is a student intern at NineSquared specialising in tracking the Australian economy.