9 January 2024

Five reasons the RBA may not cut interest rates in 2024

Market pricing for the Reserve Bank has shifted substantially over the past month, despite little local data and few published remarks from the RBA.

On December 5, 2023, overnight index swap pricing had no RBA cuts fully priced until February 2025. Now, however, 47 bps of cuts are priced over 2024, with a full cut priced by August 2024.

The move appears to have largely been driven by shifting global central bank expectations, particularly signs that the US Fed may be cutting sooner than previously thought.

But there are lots of reasons to think that Australia’s central bank may take much longer to deliver easing, particularly than the US. Here are five reasons the RBA may not cut in 2024.

First, core inflation is still well above the RBA’s target and is being held up by sticky components, particularly rents, which mean it is likely to fall only slowly. In contrast, for example, US core inflation has fallen sharply already.

Over the past six months, the US core personal consumption expenditures price index has fallen to average 1.9 per cent annualised month-on-month (down from 3.8 per cent six months earlier), close to the Fed’s 2 per cent target.

In contrast, Australia’s trimmed mean consumer price index has been 4.5 per cent annualised quarter-on-quarter over the past two quarters, which is well above the RBA’s 2-3 per cent inflation target, particularly given the focus on the target midpoint in the central bank’s recently-refreshed monetary policy mandate.

Sticky components, like services, have been holding up inflation at an above-target rate.

Part of the challenge is that rents have been rising rapidly and, given a hard-to-fix housing supply shortage, are set to remain strong for some time yet.

Housing construction is well below the rate needed to meet population-led demand growth, and there are a range of structural headwinds for residential construction.

The lag between newly negotiated rent prices and the effect on all rents means this will support elevated inflation for some time yet.

Second, productivity in Australia has been very weak, driving unit labour costs to be much stronger than is consistent with the RBA’s inflation target.

This is part of what is holding up inflation, particularly services inflation, as labour is a key input into services production.

Again, this contrasts with the US, where productivity has rebounded and unit labour cost growth has fallen sharply.

In Australia, labour productivity in Q3 2023 was 6 per cent off its peak, and down 2.1 per cent year-on-year, while nominal unit labour costs were up by 6.4 per cent year-on-year in Q3 2023.

It’s not clear that recent supply-side policy changes will help lift productivity, particularly on the industrial relations side.

Third, the RBA has a policy setting that is likely to be less contractionary than that of the US Fed, ECB or Bank of England, given the RBA tightened by less than these central banks. The RBA has hiked by 425 bps, while the Fed did 525 bps, ECB did 450 bps and Bank of England did 515 bps.

The RBA’s cash rate is, arguably, less far above a “neutral rate” than in these other economies, and is therefore delivering less drag on the economy.

Much of this was by design, with the RBA purposefully prioritising an economic soft landing, and stating that it was prepared to be more patient about dis-inflating the economy.

This strategy would also imply that the RBA is likely to be one of the last central banks to cut.

Fourth, although Federal fiscal policy has been fairly well aligned with the inflation fighting objective, come mid-year we see it as likely to loosen somewhat.

Part of this reflects already legislated Stage 3 tax cuts that start on July 1 and seem unlikely to be repealed.

We see this as supporting consumer spending and inflation, given we expect consumers to treat the tax relief as additional income, for which they have a higher marginal propensity to consume out of.

In addition, recent statements by the Prime Minister suggest further ‘cost of living’ relief may be part of the Budget 2024-25 in May, as we head towards the next election, which needs to be held before 27 September 2025, according to media reports.

State government budgets have also been more expansionary than the Federal fiscal settings recently.

Finally, still high commodity prices, driven by supply constraints, geopolitical uncertainty, the energy transition and an expected ongoing policy-driven recovery in China, are set to underpin national incomes and the resources sector.

The recent rise in iron prices appears to reflect part of this story, with the price currently above $US140 tonne.

We expect the global energy transition to be a positive for Australia’s growth and national incomes.

Our central case is that the RBA is likely to be on hold through 2024, with cuts not arriving until 2025.

In the short run, there is still some risk that the RBA hikes again in coming months.

By the second half of the year, the risk gets larger that cuts could arrive, but the reasons listed above are why this is not our central case.

This article first appeared in The Australian on 8 January 2024.