Cliff Notes: the enduring impact of inflation
Key insights from the week that was.
Q2 GDP for Australia came in as anticipated at 0.4% (2.1%yr). One of the key themes of the report was ongoing weakness in the consumer, household spending eking out a 0.1% gain in Q2. While it was encouraging to see gross disposable incomes rise 1.8% in the quarter, the impact of higher interest costs, tax payments and price increases was material, leaving households’ real disposable income down 0.1% in Q2 and –3% over 2022-23. Households once again had to draw-down on their savings to fund spending, the savings ratio falling from 3.6% to 3.2%. That discretionary spending declined –0.5% as consumption of essentials rose 0.5% highlights the degree of pressure on households’ budgets and the trade-offs having to be made.
With the cash rate now at its peak and inflation gradually abating, real discretionary spending capacity will remain under pressure but likely improve at the margin. Regarding other areas of the domestic economy, business investment rose in response to generous tax incentives and the improved availability of goods, a rise in equipment spending driving the 2.1% gain in new business investment overall. While the outlook for the private sector is clouded, public investment’s strength likely has further to run given the sizeable pipeline of work.
On trade, Australia’s current account surplus narrowed from $12.5bn in Q1 to $7.7bn in Q2. This was primarily driven by a pull-back in the terms of trade, -7.8% in Q2. In real terms however, the lift in export volumes (+4.3%) outpaced that of imports (+0.7%), leading net exports to contribute a sizeable 0.8ppts to GDP growth in Q2.
As discussed by Chief Economist Bill Evans, the RBA’s decision to leave policy unchanged for a third consecutive month was hardly a surprise given the constructive data flow of late. Given the growing evidence around moderating wage pressures, persistent weakness in consumer spending and some tentative signs of a softening in labour market conditions, the Board’s concern over upside risks to inflation should continue to fade. Westpac remains of the view that as these dynamics evolve and growth holds firmly below trend, there will be scope for the RBA to shift towards a rate cut cycle beginning in August 2024, to ensure GDP growth can sustainably return to trend as inflation nears target in 2025.
Offshore, North America was the focus.
The Bank of Canada kept rates steady at 5.0% at their September meeting, but voiced a hawkish bias. Of note, the statement mentioned they are “prepared to increase the policy interest rate further if needed”. This is in contrast to their January meeting statement when the Bank believed the hiking cycle had most likely been concluded, commenting "If economic developments evolve broadly in line with the MPR outlook, [the] Governing Council expects to hold the policy rate at its current level while it assesses the impact of the cumulative interest rate increases." September’s more hawkish tone points to greater sensitivity to upside inflation risks which is likely to remain until inflation risks fully abate. The statement also referred to persistent underlying inflation pressures which pushed headline inflation from 2.8%yr in June to 3.3%yr in July. The Canadian economy meanwhile contracted 0.2% annualised in Q2, bringing the annual growth rate down to +1.1%yr at June compared to the BoC's forecast of 1.7%yr back in July. Weak growth should see inflation cool over the months ahead, allowing the central bank to remain on hold. However, there are risks the CPI will remain stubbornly above target.
The US Federal Reserve's September Beige Book and the August ISM non-manufacturing survey was consistent with a sanguine outlook for the US economy. The Beige Book reported that consumer spending on tourism was strong while non-essential retail spending slowed. Auto sales were an exception; however, this strength was seen as a consequence of improved supply. Many districts reported that spending was likely being financed by credit versus income, arguing for a pull-back in consumption growth soon, particularly given the recent rise in consumer credit delinquencies and as student loan repayments recommence. Job growth was also seen as subdued across the nation, and contacts in nearly all districts signalled an intention to slow wage growth “in the near term”. For business, profit margins reportedly fell in several districts, highlighting an emerging lack of pricing power amongst businesses.
The ISM non-manufacturing PMI for August was an above expectations result, the headline index rising to 54.5 with gains across the board except for the backlog of orders. These results and the optimism reported by respondents implies moderate to solid growth can continue for the foreseeable future. Notably, the prices paid component of ISM services increased 2.1pts after an even larger jolt higher in the manufacturing PMI prices series last week. The market took both results as a signal of renewed US consumer inflation risk. However, per the Beige Book, if businesses are increasingly finding it difficult to pass cost increases on, the impact on CPI inflation should be negligible, or at least slow to come through. Lastly, ISM services employment saw a 4pt gain, but the PMI index remained below the long run average. On a multi-month view, this survey is still consistent with job creation slowing to a rate consistent with balance between demand and supply.
This week, we also updated our US growth outlook (PDF 41KB) following stronger than expected consumption growth in June and July. Annual growth in 2023 and 2024 has been revised up from 1.0%yr in both years to 2.0%yr and 1.3%yr. Our early estimate for 2025 is also benign at 1.5%yr. Less downside risk for GDP growth argues for the FOMC taking their time in easing policy. So, while we still expect the first rate cut from the FOMC in March 2024, the pace of rate cuts is no longer expected to accelerate thereafter. Instead we see only one 25bp cut per quarter through to the end of 2025, when the fed funds rate is forecast to be 3.375%, a level modestly above our estimate of neutral. Higher for longer US interest rates will have implications for the Australian dollar. AUD/USD is now seen at USD0.66 end-2023, USD0.70 end-2024 and USD0.73 end-2025. Our New Zealand team subsequently also revised their forecasts for NZD/USD and the NZ 10-year yield.
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