Balanced Risks Suggest Rates Should Remain Steady Again: RBA Shadow Board

At 3.8% year-on-year, Australia’s quarterly consumer price index (CPI) inflation rate in the June quarter was slightly higher than expected, and an increase of 0.2 percentage points from the March quarter. At the same time, the trimmed mean measure of core inflation equalled 3.90% year-on-year, down from 4.0% in the previous quarter, still well above the RBA’s target band of 2-3%. Labour market data remains surprisingly robust, despite recurrent predictions of significant weakening. Financial markets, and especially the housing market, remain bullish, while downside risks persist for the global economy. Once again, the Shadow Board recommends holding the overnight rate steady at 4.35%, attaching a 48% probability that this is the optimal policy setting.

In June 2024, the seasonally adjusted unemployment rate increased by 0.1 percentage points to 4.1%, despite an increase in employment of more than 50,000 persons. Accordingly, the participation rate edged up from 66.8% to 66.9%. Encouragingly, the rise in employment was primarily driven by an increase in full-time positions, which grew by over 43,000. The underemployment rate dropped from 6.7% to 6.5%, and total monthly hours worked in all jobs swelled by 0.8% in seasonally adjusted terms. The latest wage price data is not due to be released until next week, after the current interest rate round. The consensus forecast is that wages growth will come in at 4.0% year-on-year in Q2 of 2024.

The Australian dollar approached the 68 US¢ in the middle of July but has since fallen 3 US¢. Since the last round, the yield on Australian 10-year government bonds has continued its decline, currently offering a yield of 4.05% (as of 4 August 2024). The short-term yield curve (2y vs 1y) remains inverted, with a spread of -37 bps; the medium-term yield curve (5y vs 2y) has recently inverted, with a spread of -9.6bps. The long-term yield curve (10y vs 2y) has shifted from “slightly convex”, with a spread of 23 bps, to flat, with a spread of 24.5 bps. The Australian stock market, like other stock markets across the globe, made new highs in July but has pared those gains in the final days of the month. The S&P/ASX 200 Index is currently trading between 7,750 and 7,800.

Consumer confidence, as measured by the Westpac-Melbourne Institute Consumer Sentiment Index, remains weak, dropping to 82.7 points in July 2024, the lowest reading in six months and well below the neutral value of 100. Retail sales rose by 0.5% month-on-month, or 2.9% year-on-year. The NAB business confidence index spiked from -2 in May 2024 to +4 in June 2024, the highest reading since January 2023. The improvement in sentiment is reflected in a slight rise of the Judo Bank Manufacturing PMI, whereas the Services PMI fell slightly, from 51.2 in June, to 50.4 in July, above the neutral level of 50 and thus indicating a sixth straight monthly expansion in services activity. Capacity utilization increased marginally, to 83.5%, well above the long-term average of 81.3%. The six-month annualized growth rate in the Westpac-Melbourne Institute Leading Economic Index, which predicts economic activity relative to trend three to nine months ahead, was again flat in June 2024. Westpac-Melbourne Institute senior economist Matthew Hassan summarized this as, “the latest Leading Index suggests slow growth is continuing to bring demand into line with supply, helping to lower inflation.”

The Australian housing market remains buoyant, with the exception of Melbourne, where average home prices fell by 0.9% in the June quarter. Record house prices were recorded in Sydney, Brisbane, Adelaide and Perth, despite concerns that elevated interest rates are hurting households. The housing market will remain tight for some time and thus continue to put pressure on household finances.

The world economy remains a source of considerable uncertainty. On one hand, the fallout from the pandemic is fading farther into insignificance. On the other, many risks to the moderate outlook for global growth of 2.6% (according to the World Bank) abound: widening geopolitical conflicts, including a large-scale war in the Middle East, trade fragmentation, relatively tight credit conditions, and climate-change related natural disasters. The World Bank emphasizes that global cooperation is required to “safeguard trade, support green and digital transitions, deliver debt relief, and improve food security.” Furthermore, “[…] comprehensive fiscal reforms are essential to address ongoing fiscal challenges.” These challenges will continue to form the backdrop for domestic monetary and fiscal policy for a long time.

On balance, the Shadow Board continues to favour keeping the overnight rate, currently equal to 4.35%, on hold. It attaches a 48% probability that this is the appropriate setting (up from 45%), a 42% probability (down from 43%) that the overnight right should increase, to 4.6% or higher, and a 10% probability that the overnight right should decrease to 4.1% (down from 12%).

A similar picture emerges for the probabilities at longer horizons: 6 months out, the confidence that the cash rate should remain at the current setting of 4.35% equals 27% (up one percentage point); the probability attached to the appropriateness of an interest rate decrease equals 33% (unchanged), while the probability attached to a required increase equals 40% (down one percentage point). However, the mode recommendation at this horizon, by a small margin, is for a raise to 4.6%.

One year out, the shift towards monetary easing is clearly visible: the Shadow Board members’ confidence that the appropriate cash rate should remain at the current level of 4.35%, equals 18% (down from 19%). The confidence in a required cash rate decrease, to below 4.35%, equals 59% (unchanged), and its confidence in a required cash rate increase, to above 4.35%, is 23% (up from 21%). Three years out, the Shadow Board attaches an 11% probability that 4.35% is the appropriate setting for the overnight rate (unchanged), an 81% probability that a lower overnight rate is optimal (unchanged) and a 7% probability that a rate higher than 4.35% is optimal (unchanged).

The ranges of the probability distributions have barely changed and are as follows: they extend from 4.10% to 5.35% for the current recommendation, from 3.60% to 5.60% for the 6-month horizon, from 2.60% to 6.10% for the 12-month horizon, and from 0.85%-5.10% for the 3-year horizon.