Heads - I win, Tails - you lose

In the high-stakes arena of the Cricket World Cup match, the captain stood at the center of the field, the coin gleaming in his hand. As it spun through the air, the entire stadium held its breath. When the coin finally landed, the captain had won the toss. Now came the crucial decision: to bat or to bowl first.

The pitch conditions clearly favoured batting, promising high scores and minimal assistance to bowlers.

On any other day, the choice would have been obvious. But today was different. The captain's team was renowned for its bowling prowess, not its batting strength. Electing to bat could expose their fragile top order, but choosing to bowl might waste the prime batting conditions. After a moment of intense contemplation, the captain chose to bowl, banking on his team's strength and the hope that they could restrict the opposition to a manageable score. It was a gamble, a decision that could either secure a memorable victory or lead to a crushing defeat. 

The Reserve Bank of Australia (RBA) Board is facing an eerily similar predicament. Parts of the economy are showing signs of weakness: consumer confidence is at an all-time low, retail spending is sluggish except during sale periods and business insolvencies are soaring. Sequential growth has been nearly flat in the first quarter of 2024. Yet, inflation has been persistently higher than expected, with its slower-than-anticipated pace of normalisation. Coupled with a resilient labour market, the central bank is justified in being concerned about wage pressures and the resultant demand for goods and services.

Now, should the central bank hike or hold?

While inflation has been the focal point, it's crucial to remember that the RBA has a dual mandate: to tame inflation while "preserving labour gains"—a phrase Governor Bullock often repeats. The real test for RBA's patience is not the slow pace of disinflation but the extremely gentle pace of easing in the labour market. Unemployment rate is inching up ever so slowly while the strength in employment growth has been surprising! Is the labour market still tight? We don't think so. In line with what most of our clients have been reporting, hiring intentions are slowing. However, that doesn't change the fact that there is still some underlying tightness in the labour market and robust jobs growth mean wages which in-turn means the capacity to spend and pose upside risks to demand-driven inflation.

 Let's break down what the deliberations are likely to look like at the Aug 5-6 meeting. 

Arguments for a Hike

 Arguments for a rate hike focus on the need to remain vigilant about upside risks to inflation. The June policy meeting minutes noted that global growth has improved since late 2023, and inflation in Australia was higher than expected. Revisions to historical consumer spending data suggest more resilience than previously assessed. Although GDP growth in the March quarter was weak, business debt growth is slightly above the post-global financial crisis average, and some central banks are waiting for more evidence of a sustainable return of inflation to target before easing rates.

 What do we think? The second-quarter CPI data (due tomorrow) is likely to be strong due to seasonal factors. This period captures school holidays, the long Easter break, and extended EOFY sales, all of which contribute to excess spending. The May monthly CPI data showed persistent price pressures, but it's important to note that many data points in the monthly series are not updated, impacting its credibility.

 In our opinion, a forward-looking central banker would prioritise future developments over back-dated data. Events from 2Q24 (April-June) have already occurred while interest rates were at 4.35%. What's crucial is what lies ahead. Federal and state subsidies kick in at the beginning of 3Q24 (calendar year), marking the start of a new fiscal year in Australia. These subsidies aim to ease cost-of-living pressures, but at what cost (some wordplay there!)? While subsidies will help reduce most cost pressures, and bring inflation down markedly, the RBA will be cautious of this "artificial" disinflation. What happens when the subsidies are revoked? Is there a risk that inflation will spike again? Many of the sectors targeted by these subsidies, such as energy and housing are critical and have not seen significant price reductions naturally.  

Arguments for a Pause

The primary argument for pausing the cash rate increase is the belief that the economy is on track to return inflation to target by 2026 while preserving employment gains. Inflation has decreased significantly from its peak, and inflation expectations broadly align with the Board’s target. Wages growth peaked in late 2023, output growth remains weak, and the output gap is closing. Revisions to consumption data, driven by imports, complicate real-time assessments of spare capacity. There are also downside risks to the labour market, such as falling vacancy rates and the potential for a quick rise in the unemployment rate. The rising number of business insolvencies could negatively impact labour demand, and many households are experiencing financial stress, adding uncertainty to the aggregate demand outlook.

 Time to look ahead. We have seen the European Central Bank (ECB) and the Bank of Canada (BoC) deliver their first cuts. On the other hand, there have been the likes of the US Fed Reserve and Bank of England who are in the wait-and-watch mode just like us. Among all these global peers, the US Fed is the most important for us from a currency POV. The RBA wouldn't, and rightfully so, want to follow the Fed in its footsteps immediately, but it will have to at some point. Policy rates are directly linked to the currency such that when the Fed cuts in September, as is widely expected, and the RBA stays on hold, as is also widely expected, the Aussie will invariably appreciate. As our currency appreciates, inflation will, in principle, start falling. Couple this with subsidies already in place, price pressures are likely to come off quite swiftly.  

 Another point on the technical side, is the concept of real interest rates. Real interest rates are essentially the difference between the RBA's policy rate and annual inflation. Real interest rates for Australia are currently positive. When real interest rates are positive, even if the central bank is on hold, the economy continues to contract. Since the last time the RBA hiked, inflation has continued to fall despite the cautious non-action stance. Remember, inflation is a lagging indicator after all.  

Conclusion

The August meeting would be a very close call. We however think there are two key lessons in this economic cycle that we need to accept: normalisation takes time and the stage of development matters. Think back to the pandemic years. The lockdowns, initially intended for just 15 days, extended for over two years. Just when we thought we had beaten the virus, new variants emerged. If we accept the bad phase to last for three years, isn't it necessary to give the economy time to recover from the after-effects?

 Hiking rates could curb inflation faster but might also stifle the economic recovery and exacerbate weaknesses in certain sectors, potentially increasing the risks of a recession. In our opinion, holding rates is the right thing to do to allow the labour market to continue on its gradual path of easing leading inflation to naturally fall to target levels over time.

 In this delicate balancing act, the RBA, much like the cricket captain, must weigh immediate conditions against the inherent strengths and vulnerabilities of the economy. Their choice will be pivotal, shaping the economic landscape much like the captain's decision shapes the outcome of the match.

FOR MORE INFORMATION

If you would like to learn more about the topics discussed in this article, please contact Devika Shivadekar.