Shadow Board’s Confidence in Required Rate Hold Strengthens

The latest data point to inflation having fallen further: the monthly consumer price index (CPI) rose 4.9% in the twelve months to July, the biggest contributors to inflation once again being housing (+7.3%), along with food and non-alcoholic beverages (+5.6%). While encouraging, this still puts the inflation rate well above the RBA’s target band of 2-3%. The official, seasonally adjusted unemployment rate increased to 3.7%, and there are signs that, while still weak, consumer and business confidence are bottoming out. On balance, the RBA Shadow Board favours holding the cash rate steady for another month. It attaches a 57% probability that the overnight rate should remain at the current level of 4.10%, a 34% probability that the overnight rate should be higher, and a 9% probability that overnight rate should be lower.

The official Australian seasonally adjusted unemployment rate increased from 3.5% to 3.7% in July, while the labour force participation rate fell to 66.7%. Job vacancies fell slightly for the fourth consecutive month but job advertisements rose by 0.4% month-over-month. The youth unemployment rate increased by nearly a full percentage point, to 8.62%; the underemployment rate held steady. Even though most indicators, by historical standards, remain remarkably favourable, the recent monetary contraction is increasingly impacting the labour market. The wage price index for Q2 grew by 3.6% year-on-year, just below the official forecast and still below inflation, pointing to a further decline in real wages. This does suggest that inflation expectations remain relatively muted, lessening the need for further rate increases.

The Australian dollar dipped below 64 US¢ mid-month as the interest rate gap relative to the US is expected to widen. Yields on Australian 10-year government bonds finished the month just above 4% but below the current cash rate. The yield curve in long-term vs short-term maturities is flat, but inverted in short-term maturities (2y vs 1yr) and in medium-term vs short-term maturities (5y vs 2y). This, too, points to inflation expectations being muted. The Australian share market posted losses in the first half of the month but regained ground later on; the S&P/ASX 200 stock index ended the month just shy of 7,300.

Consumer confidence, as measured by the Melbourne Institute and Westpac Bank Consumer Sentiment Index, held steady in the past month but remains in “deeply pessimistic” territory. On the upside, retail sales in July expanded by 0.5% month-over-month. Business confidence is still suffering. The Judo Bank Australia Composite PMI and Services Sentiment indicator fell for the fourth consecutive month, from 48.3 to 47.1 (the lowest number in 19 months), and from 47.9 to 46.7 (the lowest since January 2022), respectively. The Manufacturing PMI was unchanged but the capacity utilisation rate increased nearly a full percentage point, to 84.48% in July. The Composite Leading Indicator edged up again, suggesting it has found a bottom after a two-year decline; the NAB business confidence index also rose, from a downwardly revised -1 in June, to 2 in July. Taken together, these numbers do not suggest the Australian economy is heading for recession following the aggressive monetary tightening of the past year and a half.

Outside Australia, there is growing concern about China’s weakening economy, with some analysts claiming the country is suffering from deflation. The Chinese property market experienced another setback when Country Garden, one of China’s largest property developing companies, applied for urgent financial assistance. While the US is fighting inflation, it appears to be avoiding recession. European economic growth is, likewise, higher than many analysts feared, Germany excepted. Geopolitical tensions (Ukraine-Russia war, Chinese-US tensions) are not going to be resolved any time soon and so will continue to weigh on global trade and production.

Compared to last month, the Shadow Board’s conviction to keep the overnight rate unchanged has strengthened: it attaches a 57% probability that this is the appropriate policy (compared to 47% in August), while only attaching a 34% probability to the need for another rate rise (46% in August). The probability attached to a required rate reduction equals 9%.

The probabilities at longer horizons are as follows: 6 months out, the confidence that the cash rate should remain at the current setting of 4.10% remained unchanged at 26%; the probability attached to the appropriateness of an interest rate decrease equals 30% (compared to 28% in August), while the probability attached to a required increase equals 44% (up from 46%). The mode recommendation at this horizon is 4.35%, unchanged from last month.

One year out, the Shadow Board members’ confidence that the appropriate cash rate should remain at the current level of 4.10%, equals 20% (compared to 16% in August). The confidence in a required cash rate decrease, to below 4.10% equals 49% (5 percentage points lower, compared to August), and its confidence in a required cash rate increase, to above 4.10%, is 31% (down 10 percentage points from August). Three years out, the Shadow Board attaches an 11% probability that the overnight rate should equal 4.10% (virtually unchanged from the previous month), a 76% probability that a lower overnight rate is optimal (down 4 percentage points) and a 13% probability that a rate higher than 4.10% is optimal (up 5 percentage points).

The range of the probability distribution for the current recommendation is unchanged from last month, extending from 3.85% to 4.60%. For the 6-month horizon the range, extending from 3.10% to 5.60%, simply shifted down 25 bps. The range for the 12-month horizon, at 2.10%-5.85%, narrowed by 25bps, whereas the range of the 3-year horizon shifted down to 0.60%-4.85%.