23 June 2024

COVID’s long tail to keep interest rates higher for longer

Making sense of the economy at the moment is more difficult than usual. Growth has almost stalled, consumer spending is weak and consumer sentiment has been very low for two years, but inflation remains too high, and sticky.

A sharp slowdown in growth would normally be associated with a decline in inflation and, before not too long, the RBA would be able to cut interest rates and offer relief. But this time, things appear to be a bit different.

As if to acknowledge just how complicated things are, the RBA last week used the word “uncertain” eight times in its short post-board meeting statement.

For us, the key explanation is that the supply side of the economy is more gummed up than usual. We see this as largely reflecting what we have described as the “long tail” or ongoing ­effects of the pandemic and pandemic-related disruptions.

As a result, despite growth slowing to a near stall speed, price and cost pressures are still too strong. This has been a key factor that has underpinned our view that the RBA is unlikely to cut its cash rate this year, a view we have held since late 2023.

One factor has been that ­labour productivity has been very weak. Productivity has fallen sharply since the early stages of the pandemic and, although it has improved a bit recently, it was still flat over the year to the first quarter of 2024.

Beyond productivity, supply has also been hampered by the ­labour market matching of workers to jobs that, although improving, still appears less efficient than it was pre-pandemic, despite the surge in migration that has boosted the availability of workers. Some part of this is due to the “long tail” effects of the hard border closures, which particularly disrupted worker availability.

Another part of the story is the impact of the forbearance measures – such as JobKeeper, the tax repayment holidays and corporate insolvency moratoriums. While these supported the economy at the time, they also prevented it from adjusting.

The housing and labour markets offer clear examples.

For housing, the reopening of the border saw a surge in inward migration in 2023 that drove strong housing demand, but the “long tail” pandemic effects have disrupted the ability of the economy to deliver new housing.

Part of this is because many construction companies use fixed price contracts, which became unprofitable after the pandemic-related surge in materials and ­labour costs. Forbearance measures prevented immediate adjustment during the pandemic, but in the past year or so there has been a sharp rise in construction industry insolvencies.

This has reduced the ability of the sector to deliver more housing supply, which in turn is lifting rents and supporting rising housing prices. In short, dwelling investment is falling, but this is not due to weak housing demand, but because of a constrained construction industry.

The labour market has been heavily disrupted too. The reopening of the economy saw a surge in consumer demand and drove strong demand for labour at a time when the previously closed border had limited labour supply.

The surge in inward migration in 2023 helped to meet some of that labour shortage, but metrics of skills matching still suggest, even now, that job matching is not yet as efficient as it was pre-pandemic. Part of the story is that a big share of the ­migration surge was international students who have probably added more to demand than ­labour supply.

The surge in student arrivals will not be repeated and other ­migrant visa conditions have been tightened, which is set to slow population growth. However, an excessive slowdown in migration could keep the jobs market tight, adding upwards pressure to wages.

Of course, there were many other pandemic-related disruptions to “normal” patterns. Excess household savings during the pandemic delayed the impact of the fiscal support, pump-priming demand when the economy was reopened. Behavioural changes, such as more flexible working arrangements, are affecting labour market dynamics, as well as housing and commercial property.

The RBA has taken a particularly patient approach, as it seeks to lower inflation but also to keep the economy close to full employment. But fiscal policymakers are not proving to be as patient, with the federal and state budgets becoming more stimulatory, alongside the stage three tax cuts.

We expect that a longer period of weak demand will be needed to get inflation to fall further.

This article first appeared in The Australian on June 23, 2024.