A week after the US Federal Reserve cut interest rates by 50 basis points, the RBA once again left the official cash rate on hold last week.
In its decision statement, the RBA cited stubborn underlying inflation as the rationale for keeping rates on hold.
RBA Unmoved by Government’s Headline Inflation Magic Trick
Last week also saw the latest monthly inflation numbers released, a day after the RBA’s monetary policy decision. It was somewhat encouraging that headline inflation fell from 3.5% to 2.7%, the slowest pace since August 2021.
However, a large portion of the decline was due to government rebates on household electricity bills. For the electricity sub-category, the combined impact of Commonwealth Energy Bill Relief Fund rebates, as well as state government rebates in Queensland, Western Australia and Tasmania, drove the largest annual fall in electricity prices on record, with a -17.9% year-on-year decline.
All things equal, these subsidies would need to be repeated next year to prevent a large rebound in electricity prices in year-on-year terms. Crucially, the RBA’s focus is on the “trimmed mean” or underlying inflation (which excludes the energy price declines). While the trimmed mean measure declined from last month’s 3.8%, it still came in at 3.4%, which is well above the RBA’s 2-3% target range.
The RBA emphasised its focus on a sustainable decline in underlying inflation in its decision statement and press conference comments.
“The board needs to be confident that inflation is moving sustainably towards the 2-3% target band before any decisions are made about a reduction in interest rates”
These comments suggest that the RBA is still some way from contemplating a rate cut.
Stickiness in services sector inflation would worry the RBA
The details of the latest CPI release were not all bad, but the RBA’s stated hurdle of a clear and significant moderation in underlying inflation is yet to be met.
While goods prices dropped to +1.4% year-on-year (from 2.8%), this was driven by the large month-on-month drop in electricity (-14.6% m/m) and also the volatile automotive fuel component (-3.1% m/m).
Services, which are currently more of a focus for the RBA in terms of the trend in underlying inflation, ticked down to 4.2% y/y (from 4.4%). Services inflation, however, is still far too elevated and sticky.
So while inflation news was better at the margin, the RBA is still likely some way from easing policy. RBA Governor Bullock cautioned that the return of headline inflation to the RBA's 2-3% y/y target must be “sustainable.” We infer this to mean one quarterly CPI print within the target band (i.e. Q3 CPI), which is unlikely sufficient enough to cut rates.
As a result, we see the RBA significantly lagging other global central banks and not delivering the first rate cut of -25bps until February 2025 at best, which is after the Q4-24 CPI.
Interest markets are pricing a cut by December 2024. This seems more a function of the expectation of more cuts from the US Fed this year. Based on the RBA’s comments last week, we continue to believe a rate cut pre-Christmas is unlikely to transpire.
Inflation the focus despite RBA’s dual mandate
The domestic economy is now expanding at a glacial pace, but the economy does not appear to be in major trouble, particularly with respect to the labour market, where jobs growth continues to be strong. This would likely encourage the RBA to keep a laser focus on inflation. Closer examination of jobs growth shows that job creation is heavily tied to government spending. Specifically, growth in “non-market services” categories such as health, aged care education and general public services jobs has dominated the picture of robust aggregate jobs growth. Jobs growth in these non-market sectors are growing at close to 8% year-on-year. In contrast, growth in private sector employment (market services) has flatlined over the past year.
At same time, GDP is growing well below trend at only 1%. Once again, excluding public sector spending, growth is close to stalling.
However, despite the weak state of the private sector economy, the RBA will continue to prioritise getting inflation back on a clear and sustainable path to its 2-3% target.
Equity Market Running on Global Rather than Domestic Stimulus
The RBA’s resolutely-on-hold stance doesn’t appear to have worried the local equity market in recent months. Despite lagging the US market over the past year, the local index has still been relatively strong, even in the face of sluggish earnings. This uptrend has been aided by an extraordinary run in the banking sector. As we discussed last week, this has resulted in very stretched valuations.
A broader and more sustainable rally is likely to require a more solid economic expansion to reinvigorate the earnings backdrop. Stronger performance from the resources sector is also likely required to sustain the Australian market rally. Last week’s stimulus news from China looks promising in this respect. The small cap sector would also likely respond well to lower policy rates. Australian small caps have perked up in recent weeks, but lagged their US peers in recent months. This is in part because of a lack of policy support from the RBA relative to the Fed. Lower interest rates for Australia does look to be on the way, but the local economy and equity market will likely need to negotiate an on-hold cash rate into 2025, until the RBA gains more confidence in the underlying inflation trend.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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