The inflation long-shot

The RBA left rate on hold at 4.35%.

Governor Michele Bullock did not have time to watch the Melbourne Cup. For many, the RBA rate decision is what truly stops the nation.

The recent big fall in headline inflation is good news but underlying inflation is yet to be tamed and may take longer to bring down than even the RBA expects. Low productivity or a slowing economy may eventually force the RBA’s hand one way or the other.

What the RBA’s Statement said

”Taking account of recent data and the updated forecasts, the Board’s assessment is that policy is currently restrictive and working broadly as anticipated.”

“While headline inflation has declined substantially and will remain lower for a time, underlying inflation is more indicative of inflation momentum, and it remains too high.”

“The forecast path for underlying inflation reflects a judgement that aggregate demand remains above the economy’s supply capacity, evidenced by the persistence of underlying inflation, surveys of business conditions and ongoing strength in the labour market.”

Statement by the Reserve Bank Board: Monetary Policy Decision, 5 November 2024.

https://www.rba.gov.au/media-releases/2024/mr-24-24.html

What the governor said at the press conference

“The Board needs to be confident that inflation is moving sustainably toward the target and we need to see more progress on underlying inflation coming down.”

“The underlying inflation we are seeing is still sitting at around 5% for services, that is a significant amount of inflation in the system and what that is suggestive of is that demand is still above supply .. and we still have a labour market that looks on the tighter side.”

“Survey measures continue to indicate that labour availability is constrained.”

“Wages growth has continued to ease but is generally still above rates consistent with inflation targets given the weak productivity growth.”

The fall in headline inflation is welcome but underlying inflation needs to fall

The fall in quarterly inflation from 3.8% in the June quarter to 2.8% in the September quarter is very welcome and as Bullock said in her media conference it will bring real relief to people.

However, the fall was mostly driven by a falling petrol prices and by federal and state government help with electricity costs (see chart below).

This means that the 2.8% is not sustainable: petrol prices will likely go up again in the near future and the government support is only temporary.

To ensure that inflation expectations are anchored in the target 2% to 3% band, the RBA needs to ensure that inflation falls into the band and stays there. That is why despite the recent good result in headline inflation, Bullock is emphasising the path and level of underlying inflation. And as the chart below shows, the battle against underlying inflation is not yet won.  

Getting underlying inflation down

To get underlying inflation down, the RBA is trying to bring aggregate demand down to aggregate supply. Aggregate demand is already slowing, as evidenced by Australia’s negative per capita GDP growth but supply, namely the labour market, remains constrained, it is not growing fast enough to catch up to aggregate demand, even as aggregate demand falls.

Further, Bullock is seeing some signs that the easing in the labour market growth may be slowing. Youth unemployment and the number of hours worked have stabilised.

“ ... there are just some things at the edges that suggest there might be a little bit of upside risk in here.” Bullock.

The RBA would love labour productivity to increase as it has recently in America. But it is forecast to fall in the second half of the year and to grow modestly over 2025 and 2026. Further, the RBA keeps revising its productivity forecast down (see chart below). So while wage growth is slowing, the RBA will be wary of any tightening of the labour market and upward pressure on wages.

“If we are not getting productivity growth that limits how far or quickly wages can rise without causing inflation.” Bullock.

Government spending

The other elephant in the room is the higher than expected federal and state government spending in the second half of the year. This has forced the RBA to revise up its forecasts of public demand over the next year (see chart below).

It is clear that the governor and treasurer know where they stand with one another but has anyone told the state governments. Queensland in particular is spending its largesse from LNG and coal royalties like no one’s business. For example, it has introduced 50 cent public transport fares.

Fortunately, the increase in public demand should offset weakening consumer demand over the next six months and is then expected to fall as consumer demand increases in the second half of 2025.

“I think the governments are well aware that inflation is the big thing here and cost of living and that is what is hurting people and I expect they will be very conscious of it.” Bullock.

What happens next?

Expect inflation rates to stay on hold until well into next year.

There is a lack of evidence that the labour market will ease significantly in the near term or that productivity will make any big strides in the near term so that means that the RBA will be focussing on wage growth, rents, and service inflation as it looks for signs that underlying inflation is falling fast enough. If these take longer than expected or change course, the RBA may be forced to raise rates.

On the other side, if consumer demand is weaker than expected in 2025, the RBA may be forced to cut rates earlier than planned.

Of course, everything could change if there are big changes to US economic policy with the election of a new president.

Impact on the Australian Private Debt Market

Australia remains on the narrow path with unemployment low and growth slowing. It remains attractive for private debt investors looking to escape the economic roller coaster elsewhere.