Reserve Bank’s massive problem exposed as rates look set to rise

RBA’s Governor Michele Bullock keeps repeating the same two words as her predecessor – and it indicates grim time ahead for everyday Aussies.

Australian households are in the midst one of the most financially difficult periods in our nation’s recent history, as the twin forces of high inflation and the largest rise in relative rates on record combine.

There was hope of a silver lining for mortgage holders, that at least the rise in mortgage rates was at an end.

But with the latest inflation figures coming in significantly hotter than expected, the consensus among major bank economists has swiftly flipped toward there being at least one more Reserve Bank Australia (RBA), potentially as early as the next meeting on the November 7.

“While 4.35 per cent should mark the peak in the cash rate, there is a risk it could tighten beyond that,” ANZ head of Australian economics Adam Boyton said.

Amidst the backdrop of a deteriorating domestic economy, global geopolitical upheaval and still uncomfortably high inflation, the path for the nation’s economy to avoid a recession has become an increasingly narrow and risky one.

Since the RBA first began raising interest rates almost 18 months ago, multiple members of the nation’s central bank including Governor Philip Lowe and Governor Michele Bullock have spoken of a “narrow path” where inflation is returned to normal and there isn’t too much damage to the labour market from the fight against inflation.

It has become something of a catchphrase for the RBA, with the words “RBA narrow path” recording over 178,000 search results on Google. But now almost a year and a half, and multiple major global geopolitical developments later, what does this “narrow path” look like today.

Governor of the Reserve Bank of Australia Michele Bullock talks of a narrow path but what does that actually mean? Picture: NCA NewsWire / Martin Ollman

A slowing economy

In September, the latest national accounts data revealed that the economy had expanded by 0.4 per cent in the second quarter of this year and by 2.1 per cent in the last 12 months. But behind the headlines the internals were quite a bit less positive that the headline number would suggest. In per capita terms the economy is now in a recession and GDP per hour worked had declined by 2.0 per cent for the quarter and was down 3.6 per cent for the last 12 months, pointing to weak productivity.

There was also evidence that households were increasingly reducing their level of savings growth, with the household savings ratio down 4.9 percentage points from this quarter last year (8.1 per cent vs. 3.2 per cent).

This reflects data produced by the Commonwealth Bank, which shows that the households of Australians 18 to 24 and 25 to 34 are not only not growing their savings, but actually spending them. With inflation outstripping wages growth over the last 12 months of comparable data by 2.4 percentage points (6.0 per cent inflation versus 3.6 per cent wages growth), it appears younger demographics are turning to expending savings to keep up with the rising cost of living.

Inflation surprises to the upside

Earlier this week, the ABS released the latest quarterly inflation figures and they did not make for positive reading for the Reserve Bank. In headline terms inflation was up 1.2 per cent for the quarter and 5.4 per cent for the year.

For the RBA’s preferred inflation metric, the trimmed mean, it was up 1.2 per cent for the quarter and 5.2 per cent for the year. In their most recent round of forecasts the RBA had pencilled in a reading of 0.9 per cent, so this was a significant surprise to the upside.

Trimmed mean inflation in Q3 was MUCH stronger than the RBA's August forecast...about 0.4ppts stronger on a year-ended basis. pic.twitter.com/toiZ1wT3uX

— Justin Fabo (@justinfabo) October 25, 2023

Its also worth noting that the recent figure was distorted significantly by the impact of electricity and childcare subsidies, as well an outsized increase to rent assistance. Without the impact of these distortions, the quarterly headline inflation figure would have been 1.6 per cent and 5.8 per cent for the year.

The electricity subsidies will eventually fade out of the data over the coming quarters, with the timeline varying by state, so this inflation has been postponed, not cancelled out.

Baked In Inflation

In recent months, the mild level of improvement in the nation’s rental market has been reversed, with vacancy rates at a national level nearing record lows according to some private data providers. As a result, data from SQM Research has seen a reacceleration in the growth of asking rents in recent months.

Currently, rental inflation as measured by the ABS Consumer Price Index is sitting at 6.7 per cent. This is significantly below the reading of all other private rental price data providers, such as CoreLogic, Domain, PropTrack and SQM. This is due to the ABS index measuring payable rents on all properties and private providers measuring what properties were being advertised for.

Various investigations of this divergence have found that over time eventually the two converge, with the ABS index catching up with the price growth seen by private providers. A recent analysis found that the lag between the Domain asking rents data and the ABS CPI rental price component was around 18 months.

The recent quarterly Domain rental report revealed that at a capital city level (which is what the ABS rental price component measures) asking rents were up 14.8 per cent year on year.

If we extrapolate that level of rental price inflation onto headline inflation, we would see a CPI reading of 0.85 per cent stemming from rents alone when the peak was finally reached in the ABS data.

War in the Middle East

Since the war between Hamas and Israel began on the October 7, the spectre of a broader conflict in the Middle East has been on the radar for governments and economic analysts alike.

In her first public remarks as RBA Governor, Michele Bullock warned that it was possible that conflict in the Middle East could lead to a slowdown in the global economy and that this could potentially also hit the Australian economy.

“So it’s really … a bit of a balancing act here on the potential implications. I think at the moment, we are a little bit more worried about the potential inflation implications of this,” Bullock said.

Looking ahead

Between the latest inflation figures coming in hot, baked in inflation and the threat of further damaging geopolitical developments, the RBA’s narrow path to a ‘soft landing’ for the economy is becoming narrower by the day.

While some demographics are much better placed to deal with rising rates and a slowing economy, for most households the outlook remains challenging. With wages continuing to grow significantly slower than inflation and the prospect of interest rates going even higher, the chance of a recession continues to rise.

Ultimately, the longer inflation and interest rates remain high, the narrower the path out of the current economic quagmire will become and eventually getting bogged down may become inevitable.