Why the RBA can still cut rates in February even after strong labour force data

The labour market has remained surprisingly resilient but these other key economic indicators show why the RBA can still cut rates next month.

The market-implied chance of the RBA, led my Michele Bullock, cutting its cash rate target by 25 basis points in February is hovering at about 70 per cent. Picture: NewsWire / Jeremy Piper

The Reserve Bank faces a tough decision at its meeting next month after the labour market remained surprisingly resilient in the final quarter of 2024.

Last month the Board said it was “gaining some confidence that inflation is moving sustainably towards target”.

That suggested it was close to starting rate cuts in line with other central banks.

With trimmed mean inflation in the November CPI undershooting expectations, stronger than expected employment reports for November and December won’t necessarily dent that confidence.

But after a lower-than-expected unemployment rate for December quarter, the central bank must indicate that the non-accelerating inflation rate of unemployment or “NAIRU” has fallen below its recent estimate of 4.5 per cent.

While the unemployment rate rose from 3.9 per cent to 4.0 per cent as expected in December, it fell from 4.1 per cent in the September quarter to 4.0 per cent in the December quarter, markedly undershooting the Bank’s expectations for a rise to 4.3 per cent.

Why NAIRU matters

However, if the RBA’s estimate for NAIRU has fallen from around 5.5 per cent in recent years it’s not hard to imagine that it has fallen further.

Wages growth is slowing despite the lower than expected unemployment rate. The US unemployment rate has followed a similar path yet the US inflation rate is coming down and the Fed has already cut rates by 1 percentage point.

Also while total employment rose by 56,326 versus 14,500 expected for December, the rise was entirely driven by part time jobs, which are more volatile. Full-time jobs fell by 23,711.

Interestingly, while noting that the participation rate and employment-to-population ratio hit record highs, the ABS media release no longer characterising the labour market as “relatively tight”.

“The labour market data, coupled with the decline in wages growth, supports our view that the non accelerating inflation rate of unemployment (NAIRU) is comfortably below the RBA’s implied estimate of 4.5 per cent and is likely to be around 4.0 per cent,” said CBA’s head of Australian economics, Gareth Aird.

What economists predict

CBA and several other banks including ANZ, JP Morgan and Goldman Sachs expected the RBA to start cutting rates next month through most expect it to wait until May.

However the surprisingly strong domestic labour market probably means that the board also needs to see a further fall in quarterly underlying trimmed mean CPI inflation at the month.

“The most important data release before the February board meeting is the December quarter CPI,” Mr Aird added.

“We believe a trimmed mean outcome of 0.5 per cent or below would be sufficient for the RBA to start normalising the cash rate.”

Financial markets took the December labour force data in their stride after lower than expected core US CPI data sparked a rally in stocks and bonds globally. The market-implied chance of the RBA cutting its cash rate target by 25 basis points to 4.10 per cent at its meeting next week hovering above 70 per cent. Another two cuts of 25 basis points was almost fully priced in by year end.

However, most economists remained unconvinced that rate cuts will start until May.

Betashares chief economist David Bassanese saw “impressively resilient strength” in the labour market as a “major reason” why the RBA should not hurry into cutting interest rates anytime soon.

Despite an uptick in the unemployment rate last month as the participation rate hit a record high, he said the jobless rate may have peaked at 4.2 per cent in July last year as it has trended gently downward ever since and employment has been strong

“Despite weak GDP growth, the economy retains an impressive ability to find jobs for the still rapidly expanding labour force,” Mr Bassanese said.

“To an extent, it could be argued that part of the weakness in GDP reflects poor productivity growth – or at least poorly measured productivity growth - given strength in care-related service sector jobs. This is either a structural and/or statistical issue that monetary policy can’t solve.

“The fact remains that employment is still booming and unemployment is low, despite continued cost-of-living pressures afflicting households.”

CPI trends to watch

A fall in the annual rate of monthly trimmed mean inflation from 3.5 per cent to 3.2 per cent in the November CPI report raised hopes that the RBA could cut rates in February, as did a fall in annual growth in the wages from a 4.3 per cent peak in December 2023 to 3.5 per cent by September 2024.

But Mr Bassanese warned that the monthly CPI report is notoriously volatile and could easily bounce back again when the December quarterly report is released later this month.

In his view easing wage growth could reflect the modest rise in unemployment from late 2022 to mid-2024, and the moderation in wage growth could be at risk if the unemployment rate has peaked. And despite lower than expected US inflation data this week, he warned of a “seachange” in the US interest rate outlook due to sticky inflation and risks around the new Trump Presidency has caused a slump in the Australian dollar which adds to inflation risks at the margin.

“An RBA rate cut in this environment – especially if it is perceived as politically motivated ahead of the Federal election – could send the Australian dollar even lower, adding to this inflation risk,” he said.

The RBA board also noted last month that possible changes in US trade, fiscal, regulatory and immigration policies after Donald Trump’s inauguration could affect growth and inflation globally and in Australia. But it was “not yet possible to determine the net impact on the Australian economy without knowing details of the scale and nature of the policies to be implemented and how other economies would respond”. China’s economic outlook and policy respond also clouds the picture.