The March quarter consumer price index (CPI) confirmed annual inflation likely peaked in the December quarter last year, with the pace cooling to 7% for the year to March, down from 7.8%.
Prices rose 1.4% over the March quarter, which was marginally above consensus, but the smallest quarterly rise since December 2021. More importantly, the Reserve Bank of Australia's (RBA) preferred inflation measures, and closely watched measures of core inflation, were also off their peaks, posting quarterly increases of 1.2%, annual rises of 6.6% for the trimmed mean, and 5.8% for the weighted median.
The breakdown suggests goods disinflation is definitely occurring in Australia, as it is elsewhere. However, services inflation jumped to 6.1%, from 5.5% in the December quarter, reaching its highest rate since 2001. This will raise concerns for the RBA, as services inflation tends to be indicative of domestic price pressures, especially wages growth, and is often stickier than goods inflation. This change in composition of price growth will make for a very close call on rates when the RBA meets next week on 2 May.
Overall, inflation has turned in the right direction, but it remains to be seen whether the central bank will be content to sit on the sidelines after its initial pause last month.
A Closer Call than Markets are Suggesting?
Markets scaled back the probability of a rate increase, ascribing only a 9% chance of a 25 basis point (bps) increase to 3.85% at the policy meeting next week. It was a 25% probability before the release.
Unlike the bond market, economists are reluctant to call the end of the tightening cycle, and many anticipate the central bank has at least one more rate rise up its sleeve.
Although the absolute level of inflation remains markedly above the RBA target, we believe the softer CPI print does keep the door open for the RBA to extend its pause from April. On the other hand, the stickier nature of domestic price pressures, which are now driving the basket, makes the May decision a closer call, raising the risk of a later hike, potentially following the minimum wage decision due in June, or the June quarter inflation data due in late July.
The pay bump of up to 5.2% for minimum and award wage workers last year is flowing through to service industries such as accommodation and restaurants. Wage bills for these industries make up a higher portion of their total costs, so the Fair Work Commission’s June decision for the next minimum wage rise (when headline inflation is likely to still be in excess of 6%) could generate wage-price persistence in the service sector. Nonetheless, the RBA can take comfort that wage pressures remain far more muted than in other economies, and rising immigration should help further contain any wage outbreak.
The next quarterly inflation report in late July will likely need to show headline inflation easing to about 6.5%, and 6% in underlying terms for the RBA to continue to hold off raising interest rates. It will still take considerable time to get back in the comfort zone. The RBA’s own forecasts for core CPI are for inflation to stay above the top of the target band (3%) until the first half of 2025.
Diverging from the Global Pack
During this current tightening cycle, the RBA's actions have been distinguishable from those of other central banks. Firstly, while most major central banks began increasing their rates in the first quarter of 2022, the RBA was delayed in doing so and only raised rates in May of that year. Secondly, and more recently, the RBA paused and held rates unchanged, breaking a trend of nearly a year of consecutive hikes. After 350 basis points of increases in the cash rate, the Reserve Bank’s pause in April was welcome – a breather to allow time to see the impact on both prices and the real economy so far. Lastly, even though this tightening cycle has been relatively swift compared to the RBA's historical standards, the pace of Australia's cash rate hikes stands out as being low in a global context.
Is the RBA Risking an Overly Dovish Policy Misstep?
In our view, the RBA's more tempered message on interest rates makes sense. There are a number of considerations that appear to support the more cautious wait-and-see approach the RBA has adopted, which explain why it has not needed to move in lockstep with the other major global central banks.
The structure of Australia’s housing lending – more variable rate and shorter-term fixed loans and very high household debt as a share of income - leaves Australian households more vulnerable to rising interest rates compared to global peers.
In the short term, this is negative for consumer activity, but in the medium term, it could be positive for the economy because it should mean the RBA does not need to raise interest rates as much to slow demand and, by extension, inflation.
Recent RBA commentary has taken a noticeably less hawkish tone compared to other central banks. We think this is because the RBA is wary of the high levels of leverage in the Australian economy, which are overwhelmingly linked to the housing market. Although it may not focus on this sensitivity in its rhetoric, we feel the RBA is acutely aware of the sensitivity of house prices and household balance sheets to the cash rate.
Australian Households Are Very Highly Geared
Australian households are also more highly geared. The average household holds debt that is at 211% of their income, a record high and the highest in the G20. For most of our global peers, household debt as a share of income has been going down (apart from Canada) since 2007. In the US, the average US household has been deleveraging since 2007, with household debt now sitting at 101% of income, down from a peak of 138%. This means each interest rate increase in Australia is more potent for the average household with debt.
The RBA is likely also weighing up an unusually large expiration of cheap fixed-rate loans in the second half of this year, with a large number of borrowers set to shift from ~2% fixed rate loans to ~5% variable rates. This will cause an additional crimping of household cash flow through 2023, which has yet to hit many households.
Historically, around 85-90% of borrowers were on variable rates, but the surge in fixed borrowing over the past two years - as households took advantage of record low mortgage rates - has meant the share of variable-rate mortgages is now around 60% of total outstanding loans. Yet, compared to global peers, this is still relatively high and means the knock-on effect of higher rates will be higher here than in other markets. Households with variable mortgages feel the impact of rate hikes as soon as their minimum repayments change, which is usually 1-2 months after the RBA changes the cash rate.
High gearing, combined with the variable-rate bias of the mortgage market and imminent “fixed-rate cliff”, makes Australia very sensitive to shifts in the cash rate. From this perspective, it makes sense that the RBA is becoming more circumspect on rate rises.
Pockets of Resilience Persist
For now, the domestic economy seems to be showing resilience to rate rises. There has not yet been a major deterioration in domestic growth fundamentals, despite recession concerns. While household spending has pulled back, which could admittedly be an ominous sign, there are still pockets of resilience elsewhere in the indicators we are watching. For instance, the monthly jobs report remains solid by historical standards, with unemployment sitting at 3.5%, the lowest in nearly 50 years.
Business conditions continue to show ongoing resilience through the first quarter of this year, edging lower but remaining well above the long-run average. Importantly, price and cost growth measures showed some easing in March. Overall, the survey results indicate the economy is still holding up and show there has been some easing in inflation, although there is still a long way to go to bring inflation back down to the RBA’s target band.
The situation in housing, as illustrated by a recent bounce in auction clearance rates and prices, seems to have stabilized for now. Whether this improving trend can be sustained is highly uncertain and, as highlighted previously, the full impact of the aggressive rate hiking cycle is yet to play out. There is a good chance this reprieve in the housing downturn could be short-lived, as the real squeeze on household balance sheets is expected to be felt in the second half of this year.
House prices are down 9% from their peak, which coincided with the start of the tightening cycle. The RBA would be aware that the house price unwind in Australia remains a key source of risk.
We see the risk of recession as low relative to other economies given our more cautious central bank and our currently strong economic momentum.
Odds of a Soft Landing Still in Our Favour
Domestically, we continue to see a path to a soft landing in 2023/24 against a backdrop of easing inflationary pressures and slower consumer demand in response to rising rates and the lagged impact of easing global inflation pressures. This should provide additional support to local equity and bond markets. However, Australia’s unique risks with regard to housing, a shifting wage setting process and distinct sector mix are worth watching.
From this perspective, we believe the RBA's more tempered approach throughout the current interest rate hiking cycle makes sense but is not without risks. The upside case is that risks of a hard landing over the next 12 months are likely lower for Australia. However, the downside case is that inflation may prove sticky, forcing the RBA to do more later this year or next year, thus increasing the risk of a hard landing (or at least a delayed recovery) down the track. For now, the headline news is that the peak in inflation is behind us, and the peak in interest rates is either here or relatively close.
RBA's Dovish Approach has Weighed on the Currency
A relatively lower peak cash rate is currently dragging on the AU$, though we believe the biggest swing factors for the AU$ are (a) whether the Fed pauses and (b) when the market seriously contemplates a Fed cutting cycle. We continue to see long-term fair value in the low 70s at least. The prospect of some incremental tightening later this year and/or a delayed easing cycle relative to the US Fed are likely to also provide upside impetus to the AU$ on a 12-month view. On that basis, we see some partial hedging of foreign exposures as worthwhile.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
About Wilsons Advisory: Wilsons Advisory is a financial advisory firm focused on delivering strategic and investment advice for people with ambition – whether they be a private investor, corporate, fund manager or global institution. Its client-first, whole of firm approach allows Wilsons Advisory to partner with clients for the long-term and provide the wide range of financial and advisory services they may require throughout their financial future. Wilsons Advisory is staff-owned and has offices across Australia.
Disclaimer: This communication has been prepared by Wilsons Advisory and Stockbroking Limited (ACN 010 529 665; AFSL 238375) and/or Wilsons Corporate Finance Limited (ACN 057 547 323; AFSL 238383) (collectively “Wilsons Advisory”). It is being supplied to you solely for your information and no action should be taken on the basis of or in reliance on this communication. To the extent that any information prepared by Wilsons Advisory contains a financial product advice, it is general advice only and has been prepared by Wilsons Advisory without reference to your objectives, financial situation or needs. You should consider the appropriateness of the advice in light of your own objectives, financial situation and needs before following or relying on the advice. You should also obtain a copy of, and consider, any relevant disclosure document before making any decision to acquire or dispose of a financial product. Wilsons Advisory's Financial Services Guide is available at wilsonsadvisory.com.au/disclosures.
All investments carry risk. Different investment strategies can carry different levels of risk, depending on the assets that make up that strategy. The value of investments and the level of returns will vary. Future returns may differ from past returns and past performance is not a reliable guide to future performance. On that basis, any advice should not be relied on to make any investment decisions without first consulting with your financial adviser. If you do not currently have an adviser, please contact us and we would be happy to connect you with a Wilsons Advisory representative.
To the extent that any specific documents or products are referred to, please also ensure that you obtain the relevant disclosure documents such as Product Disclosure Statement(s), Prospectus(es) and Investment Program(s) before considering any related investments.
Wilsons Advisory and their associates may have received and may continue to receive fees from any company or companies referred to in this communication (the “Companies”) in relation to corporate advisory, underwriting or other professional investment services. Please see relevant Wilsons Advisory disclosures at www.wilsonsadvisory.com.au/disclosures.