RBA on hold, but for how long?

Despite this week’s defiance, interest rate cuts are inevitable in our view. 

The Reserve Bank of Australia has consistently pointed to strength in the labour market providing a source of comfort to the economic outlook in Australia. The RBA stated in its board meeting minutes earlier this month that “Members also discussed the scenario where inflation did not move any higher and unemployment trended up, noting that a decrease in the cash rate would likely be appropriate in these circumstances,". Here the RBA clearly stated the conditions for cutting the cash rate – inflation remains lower than expected and that the trend in unemployment starting to rise. Despite weak and decelerating inflationary pressures, following solid employment growth in Q1 and high vacancy rates, we took the RBA on their word and forecast a hold on the official cash rate. 

But following Tuesday’s decision, the RBA is saying a further improvement in the labour market will be required to return inflation to its mandated target range. Tuesday’s statement said, “further improvement in the labour market was likely to be needed for inflation to be consistent with the target.” Likely a reflection of the fact that the current underutilisation rate is too high to present enough wage price pressure to materially boost wages. 

However, this is statement is somewhat ambiguous and has left market participants second guessing whether the RBA’s reaction function has shifted. Has the hurdle for a cut changed, and does this mean the RBA now needs to see the unemployment rate falling (not steady) to avoid cutting rates?

Given the lack of clarity, next Tuesday will be an important day for RBA watchers, Governor Lowe’s speech could be vital in resolving the current confusion. The minutes of last week’s May monetary policy meeting will also be released on the same day, so current ambiguity could be rectified in the minutes also.  

Until then all eyes will be on the labour market as the RBA have cited that labour market is the crucial to the outlook for monetary policy. This places the labour market data for April (16 May) and wages data for Q1 (15 May) in the spotlight this week. 

Even if the new hurdle to cut the cash rate is that the unemployment rate no longer needs to rise, given that the RBA have been so reluctant to ease they will likely need clear signs it is no longer falling. This means 2 or 3 months of labour market data might be needed to confirm the flat trend after robust employment growth in Q1, so cuts are unlikely to be imminent, given that labour market data is notoriously volatile. The standard error on the change in employment each month is around ±30,000. By that time flagging growth momentum and the weakness pointed to by several leading indicators may have caught up with the labour market already.

Although not imminent, it is likely an inevitability that the RBA will need to move to cut rates twice in the second half of this year. The RBA remain too optimistic about the domestic outlook and easier monetary policy may be unavoidable. The RBA is operating policy in the rear-view mirror as the unemployment rate is a lagging indicator of economic activity, the slowdown in growth since the second half of last year takes businesses time to respond to. Several leading indicators are pointing to a slowdown in hiring ahead; ANZ job ads and NAB business survey capacity utilisation (pictured below).

The AIG PMI employment sub-indices also illustrate that weakness in hiring could be just around the corner. It is likely only a matter of time before the upcoming softness implied in leading indicators creeps into the labour market. Persistent sub-trend growth will eventually lead to a slowdown in hiring and pick up in unemployment. 

Another problem is that construction is one of the largest employment sectors, making up nearly one in 10 jobs in Victoria and New South Wales. As residential construction activity deteriorates over the coming months, this will hit jobs. Employment will not continue to hold up as confidence is eroded and growth continues to lose momentum. As unemployment trends higher, the RBA’s hand will be forced, albeit reluctantly, as inflationary pressures remain weak and growth is below trend.