The RBA highlights the key to the policy debate – the risks to the inflation forecasts from sticky services inflation.
The Reserve Bank’s May Statement on Monetary Policy shows that the Bank has lowered its growth and inflation forecasts for 2023 from the February Statement.
The forecasts in the May Statement assume the cash rate peaks at 3.75%, which is in line with the assumption used in the February SOMP, while the AUD assumption is around 4% lower on a TWI basis.
Forecast growth for 2023 has been lowered from 1.6% to 1.2% reflecting weaker outcomes in both household consumption (1.7% to 1.3%) and business investment (3.7% to 2.3%).
Despite these changes and the boost to population growth the unemployment track is unchanged. (3.6% in June; 4.0% in December)
Inflation forecasts have also been lowered “due to slightly weaker than expected March quarter outcome”.
Headline inflation in 2023 has been lowered from 4.8% to 4.5% and trimmed mean inflation has been lowered from 4.3% to 4.0%.
However, the inflation path does not change through 2024 with headline inflation in 2024 still forecast at 3.2% (trimmed mean 3.1%) and 2.9% (trimmed mean 2.9%) by June 2025.
Wages growth has also been downgraded from 4.2% to 4.0% in 2023.
The Bank notes that “the downgrades to the labour market and labour costs offset a stronger outlook for rent inflation and a small depreciation in the exchange rate.”
The weaker growth outlook is also putting some further downward pressure on inflation through, “retailers have increasingly cited weaker demand as a constraint on their ability to increase prices.”
We were given a “flavour” of the Bank’s concerns for the risks to the inflation outlook in the Governor’s statement following the May Board decision to raise the cash rate by 25 basis points. He emphasised his concerns with the resilience of services inflation – consistent with observations overseas.
In turn those services pressures that are largely linked to wages growth are exacerbated if productivity growth in the services sectors remains weak. This theme figures prominently in the commentary, “services inflation is expected to remain high in 2023… growth in unit labour costs is expected to be solid over the forecast period, adding to cost pressures for labour intensive market services.”
This dynamic is worrying the Bank. “Inflation could also be more persistent if productivity growth does not pick up, which would make the current outlook for labour costs more inflationary than anticipated.”
On the other hand, there is some recognition of the link between the softening of demand that is recognised in the lowering of the growth forecasts and inflation through goods inflation. “If prices for consumer durables reversed one third of the price increases recorded since the onset of the pandemic, year ended inflation would be around half a percentage point lower than the current forecast … inflation would be around the middle of the target range in the second half of 2024, instead of being above it.”
So, the key theme in the SOMP is the risks around the inflation outlook given the evidence both domestically and offshore that services inflation is slow to fall. That can be explained by the ongoing tightness of the labour market holding up wages growth and poor productivity in the market services sector which is boosting unit labour costs.
This dilemma appears to have recently become a source of considerable frustration for the Board. Their policy instrument – interest rates – is doing its job in restraining demand as demonstrated by the significant downward revisions (from the already modest forecast pace) to household spending and investment growth but has had no real success in easing pressures in the labour market or, as is to be expected, boosting productivity.
The Board is also looking abroad at similar messages, “Globally…services price inflation remains strong and could prove to be quite persistent.”
What does this message mean for the policy outlook?
The Bank’s current forecasts are based on no further increase in the cash rate. That differs from the February forecasts where the same 3.75% peak in rates was embedded in the forecasts. (At the time of the February Board meeting the cash rate was 3.10%). The forecasts still indicate that the 2.9% “target” of inflation will be reached by mid 2025.
Consequently, despite the guidance that “Some further tightening of monetary policy may be required.” the forecasts indicate that is not expected to be necessary to achieve the long-term target of 2.9%.
But forecasts are not definitive – particularly two years out.
We expect that if there is to be another hike (which is not our current base case) it will come at the August Board meeting when a complete picture of developments in overall inflation and services inflation will be available from the June quarter Inflation Report.
The Bank’s forecasts indicate that the Board will, by August, still be observing a record tight unemployment rate (3.6%); a fall in trimmed mean inflation over the quarter from 6.6% to 6.0%; a fall in headline inflation from 7% to 6.3%. Those results would be necessary to support the Board’s view that it is still on target to achieve the 2.9% by June 2025. Our current inflation forecasts suggest that the results would give the Board encouragement that inflation is slowing more quickly than they had expected.
Spending growth is expected to be slowing sharply with GDP growth and consumer spending growth down to 1% (annualised) in the first half of 2023 – in line with our own forecast.
Globally, while labour markets and services inflation may be holding up, spending growth is expected to under extreme pressure – with a real prospect of a US recession and the FOMC firmly on hold.
In some ways this scenario is similar to the data observed in May – tight labour market; inflation still way too high (but lower than expected).
But the evidence of the impact of the monetary policy tightening on real activity is expected to be much more sobering by August than we saw in May.
Our central case remains that a positive surprise on lower than expected inflation; evidence of the impact on demand of the accumulated rate hikes; and offshore pessimism will be enough to keep the Board on hold in August. But the eery comparison of the likely tight labour market and robust services inflation with May certainly indicates upside risks to our scenario.