The Grumpy Hawk and Other Scenarios
Current slow growth should start to pick up in the second half of 2024 as the factors weighing on household incomes ease. Scenarios that could send things off track include geopolitics, sticky domestic inflation and ongoing consumer weakness.
Growth in economic activity is expected to be soft in the first half of 2024, driven by weak consumer spending. Beginning in the second half of the year, it will gradually pick up as the factors weighing on household income ease and consumer spending recovers.
Inflation is falling, despite the upside surprise in the March quarter and April month. Monetary policy is restrictive and helping to dampen discretionary spending and so domestic inflation. Wages growth has already peaked; the March quarter result for the Wage Price Index was slightly below our expectations and the detail suggests that this was not simply noise. This implies that domestic labour cost pressures have peaked.
With the RBA in data-dependent mode, surprises in the data flow could change the timing of rate cuts, but not the underlying decision process. The RBA Board recognises that monetary policy is currently contractionary. At some point, it must reduce that restrictive stance and return to something closer to a level it considers to be ‘neutral’. Otherwise, inflation would eventually decline below the target range. Because monetary policy works with a lag, rate cuts need to start before inflation has returned to target.
The question the RBA Board will be asking itself is what it needs to see to be confident that inflation will return to target soon. The likely trajectory of disinflation from here precludes a rate cut much before November. Trimmed mean inflation was still a full percentage point above the top of the target range over the year to the March quarter. Services inflation – a key focus for the RBA Board at present – remains elevated. It will take time for enough evidence to accumulate to convince the Board that the disinflation is on track. But if things turn out as we expect, a forward-looking central bank would want to start reducing the restrictiveness of policy by about November.
What could send things off track from our base case?
As always, there are many shocks that could push outcomes away from our base case. Most of these would be inflationary rather than deflationary. For example, geopolitical tensions could boost energy prices or global goods prices via trade restrictions or a further increase in shipping costs. Domestic supply chain capacity also appears to be still quite constrained relative to peer economies. A few upside and downside scenarios are of particular note.
Upside scenarios
The main thing that would cause the RBA to shift its first rate cut later is inflation remaining sticky above the target range. Recent communication from the Board has focused on services prices, which include non-discretionary services such as rent and insurance where inflation has been very high recently. Inflation in discretionary goods and services is much lower and in many cases is already back in the 2¬–3% target range. It is possible that consumer spending recovers more than expected in response to tax cuts and other fiscal support measures, and so pressure on firms to limit price increases wanes. The spending plans implied by responses in the Westpac–Melbourne Institute Consumer Sentiment survey would suggest that this is a lower probability scenario than previously thought. But after such a long period of cost-of-living pressure, households might instead want to unwind past cutbacks quickly.
Another possible pathway to a later start to the rate-cutting phase would be a stronger outlook for labour costs than expected. This could occur if the Fair Work Commission decision scheduled for Monday awards a larger increase to award and minimum wage rates than we expect, and other bargaining streams follow. Our wages growth forecasts assume an outcome around 4½% but anywhere in the 4–4 ½% range seems reasonable. Another scenario in this vein would be if productivity remains low because of domestic supply constraints, which would also imply that unemployment remains lower than expected. Again, given our analysis pointing to the productivity slump unwinding, this seems unlikely.
A more plausible, and pessimistic, scenario is one where domestic demand and especially consumption remain soft, but supply-driven inflation in key sectors such as housing, insurance, health and especially energy keeps aggregate inflation too high for the RBA Board’s comfort. This ‘grumpy hawk’ scenario would see weak consumer sentiment and a softening labour market collide with difficulties expanding supply in these key sectors.
A particular risk is the domestic energy cost outlook. In Europe, gas prices escalated sharply after Russia’s invasion of Ukraine, but then unwound almost as quickly. By contrast in Australia, the forces pushing up electricity and gas prices are largely home-grown and stickier. Ongoing rebates may manage to ‘tunnel through the mountain’ and meet up with a falling wholesale price on the other side. On current information, though, governments in Australia could end up needing to extend rebates even further to avoid a delayed escalation in household energy bills in a year’s time.
Downside scenarios
There is not enough time for the RBA to see enough evidence of a downside surprise to move much before November. Even if June quarter CPI is much weaker than we expect – a low-probability event – the RBA will want to see more than one quarter of downside before forming a conclusion.
If domestic demand growth slows rather than starting to recover over the course of this year, or the labour market starts to contract, the inflation outlook in 2025 and beyond will be noticeably weaker. If this turns out to be the case, then the RBA will probably seek to unwind the restrictive stance of policy faster than we currently assume. This would imply a faster decline to the low 3s and possibly beyond, rather than an earlier start.
There are a few ways domestic demand could fail to pick up as forecast. In the minutes of the May Board meeting, the RBA indicated that it had been surprised that households had cut back on spending even when their incomes had not fallen. This suggests that consumption has been more interest-sensitive than expected in a high-inflation context. Another possibility – as hinted at by the results of the latest consumer sentiment survey – is that consumers spend less out of the forthcoming tax cuts than they normally would out of extra income.
Another way inflation could be lower in the short term is if the unwind in goods inflation turns out to be larger than we or the RBA expect. Currently, the RBA assesses that the disinflation in goods prices is complete. The detail of the April CPI also points to more upside than downside risk in prices of clothing and some other consumer durables. But if demand remains soft, discounting could resume.
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