Recent resilient global jobs data and the stalling of inflation’s progress toward central bank targets have stirred notions of a ‘no-landing’ scenario for some economies. Together with the reality that the ‘last mile’ of the disinflation journey was always likely to be difficult, fears have grown that forecast rate cuts in 2024 may be delayed until 2025. In this month’s Core Offerings, we argue that when viewed through the lens of ‘real rates’, moderate H2 2024 global rate cuts remain on track. Arguably, the hurdle for further cuts in 2025 is higher.
For Australia, the risk of delayed cuts in 2024 is also higher. Reasons include industrial relations changes that hamper productivity, through to likely additional cost-of-living relief in next month’s federal budget on top of now more stimulatory third-stage tax cuts. We discuss the case for and against delaying cuts until next year, and why we still expect some rate reductions this year. However, we also consider why those rate cuts may lag other key economies, as well as the likely implications for the Australian dollar and house prices.
The market narrative has now shifted to worries about ‘no landing’ in the US economy, where growth and inflation doesn’t slow worries have also shifted to focus on the so-called ‘last mile’ for inflation, where getting inflation from a little ‘above’ target to actually ‘within’ target proves surprisingly difficult.
Equity and bond markets came into 2024 laser-focused on ascertaining that moment when key global central banks would deliver their first rate cut. Peak inflation risk had passed, and peak policy tightening had been reached in 2023. If (modern) history were any guide, rapid-fire rate cuts would soon follow. Entering 2024, this was clearly on the market’s mind.
Yet, the monetary policy outlook—and the timing of the first interest rate cut—was always going to be a battle between when global central banks gained confidence that they had done enough (revealed by slower economic growth and some rise in unemployment) and the risk they hadn't done enough (evidenced by a stalling of inflation's progress toward their inflation targets). Inflation’s journey lower was never going to be a straight line.
There was extreme optimism around the turn of the year that all was on track for March/April rate cuts, driving bond yields lower and equity prices higher. But, as in all epic battles, the underdog fights back. Jobs markets proved resilient to signs of slowing growth (particularly in the US, but also in the UK and Europe) and progress on disinflation stalled in early 2024 (levelling out in Europe and Australia, while reaccelerating in the US).
The market narrative has now shifted to worries about ‘no landing’ in the US economy, where growth and inflation doesn’t slow. And worries have also shifted to focus on the so- called ‘last mile’ for inflation, where getting inflation from a little ‘above’ target to actually ‘within’ target proves surprisingly difficult.
Could rates cuts be delayed until 2025 in the US and elsewhere? This concern has led bond markets to partly reverse their stellar gains around end-year, seeking evidence that rate cuts are still on the cards. Equities, in contrast (and not unusually), have continued to trend higher, ‘looking across the valley’ in the hope cuts are still coming. Notwithstanding strong bond and equity returns through Q4 and Q1, investors could be forgiven for lamenting a 2024 outlook—at least for traditional assets—where they are trapped between now less compelling fixed interest returns and uncompelling (and vulnerable) equity returns.
Investors could be forgiven for lamenting a 2024 outlook—at least for traditional assets—where they are now trapped between less compelling bond returns and uncompelling (and vulnerable) equity returns.
We continue to expect enough progress on inflation toward targets and sufficient (though moderate) softening of jobs markets to create the comfort central banks need to begin trimming rates modestly from mid-year.
Still, as we discussed in our 2024 outlook, The path ahead points to lower rates, published in December last year, we expect this tussle to continue through much of H1. However, battles typically end. We continue to expect enough progress on inflation toward targets and sufficient (though moderate) softening of jobs markets to create the comfort central banks need to begin trimming rates modestly from mid-year.
Looking through the lens of central banks, the ‘softer’ landing for economies does not preclude some trimming of currently ‘restrictive’ rates, given how far inflation has corrected lower. Central banks focus on real (not nominal) interest rates. By their own admission, policy is now restrictive (see chart on next page). When rates are near their peak, the risk of holding rates too high for too long (and causing recession) exceeds that of not being high enough. As such, trimming rates is the path of least regret when inflation falls.
Through that lens, a modest 0.5-1.0% reduction in rates during H2 in 0.25% increments still seem the most likely course of action. Indeed, this is broadly what most major central banks have indicated. During March, the US Federal Reserve (Fed) re-signalled three rate cuts in H2 2024, and European Central Bank (ECB) President Lagarde reiterated that by June the ECB would have more data on wages and inflation and could begin its rate- cutting cycle. Bank of England (BoE) Governor Bailey noted in his commentary that “we are not yet at the point we can cut rates but things are moving in the right direction.”
Markets have mirrored central bank signals, targeting around three cuts in H2 2024 and about the same in 2025. Whether the ‘path of least regret’ argument extends to 2025 remains to be seen, and will require further moderation in inflation toward targets. We would argue the risk of disappointment around rate cuts is greater in 2025 than 2024.
No doubt, excess pandemic savings and relatively tight jobs markets will deem this one of the milder growth downturns historically. That, however, appears still quite a distance from the no-landing thesis.
Markets have mirrored central bank signals, targeting around three cuts in H2 2024 and about the same in 2025. We would argue the risk of disappointment is greater in 2025 than in 2024.
Much of the above parallels to the situation in Australia. The Reserve Bank of Australia’s (RBA) has recently taken courage from a softer trend in jobs and underemployment and inflation correcting closer to target, moving its policy guidance broadly neutral. Still, compared to the ECB, BoE and Fed, this appears a less ‘cut-ready’ position than offshore.
We have also seen a cavalcade of credible commentators arguing that despite offshore developments, interest rate cuts in Australia should be delayed until 2025. With the timing seemingly more contentious in Australia, we take a look at arguments for and against moving this year and delaying the start of the rate-cutting cycle until 2025.
“In Q4, real household consumption continued a trend of sharp slowing, to only +0.1% q/q, after a contraction in Q3 (-0.2%). Momentum remains weak, but is stabilising, with y/y growth holding 0.1%, albeit the weakest since the GFC (excluding COVID lockdowns).”
Policy is restrictive and has been for some time: As the RBA recently noted, “financial conditions were considered to be restrictive overall. The tightening of policy had led to a significant rise in household debt payments, which, in combination with other factors, was weighing on disposable incomes and consumption”. As shown in the chart below, real rates are positive and around levels the RBA has begun trimming rates in the past.
Modest policy easing only avoids policy getting tighter in H2: With inflation expected to moderate further, from 3.4% now to 3.1% by end-2024 (based on RBA forecasts), the real rate will become even tighter ahead. For a forward-looking central bank, modest rate cuts in H2 2024 will work to avoid policy becoming even tighter than it is at present.
Consumer spending is already at its weakest since the GFC: As the RBA has previously discussed, due to the high floating-rate exposure of Australian borrowers, the rapid rise in policy rates (13 in 19 months and up by 4.25% to 4.35%) suggests they are more potent than rate hikes in the US (where rates rose to 5.50% and among the most potent among key economies). While excess pandemic cash flows have helped households adjust, latest data reveals a significantly weak consumer environment. As UBS recently noted, consumer spending growth “is holding +0.1% y/y, the weakest since the GFC (excluding COVID)”.
Spare capacity in the jobs market should ease wage growth concerns: Despite the volatility and strong gain in jobs in the recent print, there is still a trend softening in the jobs market. The three-month trend in jobs gains has slowed to 23,000 from almost 40,000 previously. Underemployment has also risen from below 6% to 6.6%, implying some easing in the jobs market. A 0.5% rise in the unemployment rate has typically been the trigger for RBA rate cuts. Unemployment has risen from 3.4% to 3.7%, a 0.3% gain.
”We expect the $9bn of additional and redirected tax cuts will result in an additional ~$5bn being spent. Equivalent to 0.4% of consumption and 0.2% of GDP. While incrementally positive for growth, such a small cash injection is unlikely to drive a material increase in inflation in FY25.”
Planned stage-three tax cuts are now more stimulating: Inflation is not yet in the RBA’s target band and unlikely to be there before next year. While the stage-three tax cuts were always on the horizon, they are now more stimulatory, given the changes shifting them to lower-income cohorts that have a higher propensity to consume. This will make it harder to slow demand and return inflation to target as planned.
The federal budget will likely add further cost-of-living relief: The Government has flagged more cost-of-living relief (fiscal stimulus) in the May budget. This is likely to further offset the impact of restrictive monetary policy, requiring it to be retained for longer.
Productivity will not improve in line with RBA’s forecast requirement: As widely reported, the recent Productivity Commission report highlighted Australia's productivity growth is now the worst in 60 years. However, the RBA’s forecast for inflation to return to around 2.5% (mid-target) by mid-2026 requires productivity to return to long-term averages. The required 1% improvement in productivity may not seem insurmountable.
However, as discussed in our recent The astute investor podcast with Business Council of Australia Chief Economist Stephen Walters, the Government’s recent changes to the industrial relations landscape are working against previously hard-won gains to labour market flexibility embedded in the earlier Hawke-Keating enterprise-bargaining reforms. Persistent annual minimum wage increases in line with inflation—without needed productivity offsets—also make the task of lifting productivity more difficult.
House prices will accelerate if rates are cut: Lowering borrowing costs will put upward pressure on house prices, accentuating an already significant social problem and potentially stimulating inflationary wealth effects. There is already a sharp supply-demand imbalance in housing construction, with building approvals recently declining to a 160,000 rate, well below average and also below the Government’s 240,000 per year new build target over five years. Rising house prices could make an already stressed rental market even worse.
As discussed in our recent The Astute Investor podcast with Business Council of Australia Chief Economist Stephen Walters, the Government’s recent changes to the industrial relations landscape are working against previously hard-won gains to labour market flexibility embedded in the earlier Hawke- Keating enterprise- bargaining reforms.
We find the arguments ‘for’ modest rate cuts in 2024 compelling, particularly the risk that allowing real rate tightening to intensify could drive a weaker growth and consumer outcome than the RBA desires. There are, however, wide-ranging views amongst forecasters, with some expecting the RBA to delay until 2025. While UBS and Barrenjoey have the first cut in November 2024, CBA expects the first cut in September 2024.
However, the arguments ‘against’, to our mind, raise concerns that the hurdle for further cuts in 2025 may be higher than many expect. We see these developments—along with the potential for another significant minimum wage decision in July (in line with inflation but absent any productivity enhancements)—as an upside threats to end-2025 cash rate targets (at 3.10% for Barrenjoey and CBA, and 3.35% for UBS).
There are wide-ranging views amongst forecasters, with some looking for the RBA to delay until 2025. While UBS has the first cut in November 2024, CBA expects September 2024, and Barrenjoey forecasts August 2024.
How the RBA views the housing market will also likely impact the outlook for rates in 2025. In many respects, the failure of government planning around land supply, the decision to allow a sharp rebound in immigration—together with the structural bias of the tax system toward housing—have divorced activity and prices from the monetary policy cycle. Even after 13 hikes and moderate correction, housing prices are once again rising due to more demand than supply. Notwithstanding lower rates may help developers increase supply, or that the RBA would view this as ‘not its problem’, H2 2024 rate cuts that accelerate price growth may still become a further headwind to cuts in 2025.
In the pre-pandemic period—with inflation trending below target—the RBA partly rationalised its penchant for following global rates lower to zero (0.1% in Australia’s case) from a currency perspective, i.e., supporting growth and inflation higher. A similar argument could now be made for the RBA to lag cuts in interest rates globally, supporting the Australian dollar higher. While the transmission mechanism from a higher exchange rate to lower imported prices (and weaker growth) to inflation is modest at best, it nonetheless would make a necessary contribution, given Australia’s greater inflation risks.
While the elevated level of commodity prices argues the Australian dollar should already be above the USD 0.75 level, it’s likely that the historically less-typical situation of Australia’s cash rate being below the US Fed funds rate is currently the key catalyst for our sub-USD
0.70 exchange rate. Anything that narrows that spread—such as the RBA moving rates at a lag to the US (and by less)—should support the Australian dollar higher. However, interestingly, over the past month or so, forecasters have typically been trimming their weaker US dollar and stronger Australian dollar views. This reflects the revised stronger outlook for the US economy, and commensurate slower Fed rate cut cycle, together with the risk of heightened geo-political volatility that may also support the US dollar.
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