Interest rates are tumbling around the world, but Australia must wait

Don’t get carried away by the buzz of sweet rate relief. Inflation is still public enemy number 1.

Jim Chalmers says headline inflation at 3.8 per cent is too high and “sticky and stubborn”. Picture, John Gass

Australia’s financial squad has abruptly tumble turned to paddle in the opposite direction: markets are now betting the next move by the Reserve Bank is a rate cut, after slightly better than expected news this week on underlying infla­tion.

The RBA board meets on Monday and Tuesday, and with core inflation drifting down for six quarters to sit at 3.9 per cent in the year to the end of June another hike in the cash rate is not on the cards. Not only that, but investors were now almost fully pricing in a rate cut by February.

“Markets certainly were relieved by the lower than expected inflation,” Challenger chief economist Jonathan Kearns said in the aftermath of Wednesday’s consumer price index release by the Australian Bureau of Statistics. “The RBA won’t hike next week and almost certainly the cash rate has peaked.

“But with domestic inflation only slowing very gradually, rate cuts are not likely to come until well into next year and will be modest when they do come.”

Deloitte Access Economics partner Stephen Smith was emphatic about the CPI result. “It should put to rest the tired notion that the RBA should lift rates, an act that would do nothing but tempt a recession,” Smith said, adding the figures were “confirmation that inflation and inflationary expectations are not running rampant”.

If you are following this flighty sentiment, data point by data point, check yourself for whiplash. Zoom out a little and consider the fundamentals at play: inflation is still too high, demand is outstripping supply and Australia’s officials, last to go up, will be some way behind their peers in easing the monetary screws.

The European Central Bank cut its policy rate in June. The Bank of Canada trimmed its key interest rate last week for the second time. The Canadian policy rate is now 4.5 per cent, compared with the RBA’s 4.35 per cent, where it has been since November. On Thursday, the Bank of England lowered its benchmark lending rate to 5 per cent.

But the big news came from the US, Thursday morning our time, where the table has been prepared by the Federal Open Market Committee for a rate cut at its next meeting next month. US inflation has fallen from 7.1 per cent two years ago to 2.5 per cent in June. The North American powerhouses are pursuing a “dual mandate”, aiming to get annual consumer price growth down to 2 per cent, across the long run, while maximising employment.

Naturally, a rate cut in mid-September, seven weeks ahead of the US election on November 5, would be politically immense. Federal Reserve chairman Jerome Powell rejected a suggestion electoral politics would guide the FOMC’s decision.

The Fed’s focus, he told reporters, was strictly on the task of taming inflation while avoiding a recession. “We never use our tools to support or oppose a political party, a politician or any political outcome,” Powell said. “Anything that we do before, during or after the election will be based on the data, the outlook and the balance of risks, and not on anything else.”

In its statement explaining the decision to keep the federal funds rate at around 5.3 per cent, where it has been since July last year, the FOMC said it “judges that the risks to achieving its employment and inflation goals continue to move into better balance”.

But it also inserted a caveat: “The economic outlook is uncertain, and the committee is attentive to the risks to both sides of its dual mandate.”

If anything, the outlook is far more uncertain for the RBA board. It’s not that the central bank’s economists are “flying blind”, as one insider put it, but the data is mixed, monetary policy lags are long and the global risks to supply chains abound.

“We need a lot to go our way if we are going to bring inflation back down to the 2-3 per cent target range,” RBA governor Michele Bullock told journalists after the June policy meeting.

At that press conference Bullock went out of her way to remind professional interest-rate watchers that “we’re not ruling anything in or anything out at the moment” when it comes to the board’s next move.

“It’s a challenging time because we’ve got balancing risks on both sides here,” Bullock said. “When we were raising rates it was quite obvious what we had to do; it’s not so obvious now.”

Our economy is stagnant, posting 0.1 per cent output growth in the March quarter – within the margin of blink and you’ll miss the signal – while continuing to generate inflation of around 4 per cent, which Jim Chalmers describes as still too high and “sticky and stubborn”. The price of essential items is growing at around 4.5 per cent a year, while discretionary inflation is at 3 per cent.

There are prices that are customarily volatile, such as petrol, fresh fruit and vegetables, and imported goods that are affected by currency movements and shipping costs. The prices of some goods and services are administered or indexed, such as university fees, rents and medical insurance premiums; the RBA can’t directly control those prices, which have escalated.

RBA deputy governor Andrew Hauser asked recently whether in setting interest rates you stripped out these administered prices and controlled the things you could control or “do you have to push the rest of the inflation basket down a little bit further in order to bring inflation back to target?”

ANZ Bank senior economist Blair Chapman took up this dilemma. “The RBA could raise the cash rate to slow inflation more sharply across the rest of the CPI basket, offsetting higher administered and indexed inflation, and bringing headline inflation back into the target band sooner,” Chapman wrote this week. “But this would likely slow activity in interest-rate sensitive sectors, slow employment growth and add to unemployment.”

On balance, Chapman believes the RBA will look through the inflation it can’t control, with ANZ economists expecting the board to consider the case for a rate hike but to keep interest rates on hold until a cut in February.

Deloitte’s Smith says the factors driving inflation – rents, bad weather and insurance claim events – cannot be fixed by the RBA’s tight monetary stance. Higher interest rates fight inflation only on the demand side by subduing spending.

“Australia’s economy is already weak, with investment and consumption in the economy too low and with business insolvencies escalating,” Smith says.

“One thing is clear, the Australian economy is not overheating. So, what would the point of lifting rates be? It would not reap the reward of bringing inflation to target any quicker.

“It would only serve to damage the economy by erasing the benefits of the stage three tax cuts – currently cushioning the impact on low and middle-income households – and recent real wage growth, threatening what could otherwise be an opportunity to pivot to investment and growth and encourage a steady economic recovery in 2024-25.”

Still, one of the nagging concerns for officials is services inflation, which is closely linked to wage outcomes. In the year to June, the price of services rose by 4.5 per cent, compared with 3.2 per cent for goods.

The Fair Work Commission has provided solid wage rises over the past two years to the lowest-paid workers. The general consensus is that with rising unemployment, now 4.1 per cent, and employers cutting back on hours, wages growth will ease to around 3.5 per cent.

Factor in the $23bn in tax cuts that began flowing on July 1, energy bill relief from state and federal governments, as well as falling inflation, and there will be a boost to family incomes over the coming 12 months.

Westpac economist Pat Bustamante has calculated governments collectively will be pumping into the economy this financial year around $55bn, in electricity subsidies, extra ser­vices and public works.

In internal advice to Bullock, the central bank’s economists judged May’s federal budget to be “slightly expansionary” for this financial year.

That all adds up to inflation risks, keeping rates higher for longer. The ABS figures showed home construction costs increased by more than 5 per cent across the past year; in Perth, the cost of new dwellings rose by an extraordinary 18 per cent across the period.

Bullock continues to tell private events that demand is outrunning the economy’s ability to supply goods and services. At one gathering this week, a business leader suggested the RBA board was balancing on a tightrope; Bullock replied it wasn’t that dire, the board still on the “narrow path” to salvation.

Bullock insists the 13 cash rate hikes are working. Not everyone agrees, which should not be surprising. “But it’s going to be a slow grind to bring inflation back,” she said at the June media conference. “We’re still hoping, forecasting to have inflation back down into the band by the end of ’25, and then ’26 we’ll hopefully be tracking to the midpoint of the band. That’s still what we’re forecasting.”

On Tuesday the RBA will publish a fresh set of forecasts. Economists at the Commonwealth Bank and Westpac, the nation’s major home lenders, are telling clients to expect the first rate cut as early as November, given the progress on inflation and the weakness in consumer spending. Again, many economists believe next year is more likely for an easing.

CBA head of Australian economics Gareth Aird says the central bank’s board “would have breathed a collective sigh of relief when the inflation numbers dropped on Wednesday” and were in line with the RBA’s forecasts in May

“Bullock had more recently upped her rhetoric around upside inflation risks following the stronger than anticipated monthly CPI outcomes,” Aird tells Inquirer. “Fortunately those risks did not materialise. The narrow path has not further narrowed. And the RBA could yet pull off the highly desired soft landing.”

Westpac chief economist Luci Ellis says given the lags in monetary policy, rate cuts need to start ahead of inflation reaching the target.

“If the board waits too long, it will risk undershooting the target for no benefit,” Ellis says. “So rate cuts are likely in the near future, provided inflation continues to traverse the trajectory that the RBA board is seeking to achieve.”

Ellis also notes “the recent comforting inflation experience of other countries”.

“It is hard to point to anything that would cause Australia to have a qualitatively different disinflation experience,” she says.

Sure, there would be bumps along the way, and homegrown issues such as high rents and the cost of home building that would keep inflation elevated, but the former RBA chief economist says Australia and its peers “are seeing the pandemic-era, supply-driven inflation surge unwind, and this is running its course”.

But Ellis cautions borrowers that interest rates will decline only gradually, with the cash rate falling to 3.1 per cent by the end of next year.

“This is likely to be the trough,” she says. “In 2026 and beyond, a period of above-average growth can be anticipated, so interest rates are unlikely to fall further from there.”