
Australian inflation is almost back in the target range of 2-3%. The Reserve Bank should begin to cut interest rates now. This will help avoid a recession as well as substantially reducing cost-of-living pressures on the one third of households with a mortgage.
Inflation outlook
The critical economic question is when interest rates will start to fall now that the inflation data released by the ABS last Wednesday show that consumer prices increased by only 2.4% over the course of 2024; well within the Reserve Bank’s target range.
The first problem is, however, that the Reserve Bank (RBA) prefers to use the trimmed mean measure of inflation which removes volatile items. This measure showed an underlying inflation rate of 3.2% over the course of 2024. So strictly the inflation rate is still not down within the RBA’s target range of 2-3%.
The second problem is that the RBA has been guided in the past, not only by its assessment of the underlying rate of price inflation, but also by its assessment of the labour market. The RBA fears that if the labour market is too tight, there is a risk of a wage-price spiral taking off if interest rates are too low.
According to the RBA the NAIRU, which is the rate of unemployment consistent with sustaining inflation within its target range, is 4½%. On that basis, with an unemployment rate of 4.0% in December, we are presently significantly below that target rate of unemployment.
On the other hand, a lot of economists, including me, think that the RBA’s estimate of the NAIRU is out of date. The labour market has changed a lot since the data on which estimates of the NAIRU are based. In particular, the membership of unions has fallen dramatically, and their power is very much reduced.
The RBA’s track record is that it has persistently over-estimated the annual rate of wage growth – by about 1 percentage point every year between 2011 and 2019 – and that is indicative of their over-estimation of the NAIRU. Admittedly the RBA did reduce their NAIRU estimate in mid-2019 from 5% to the present 4½%, but they now need to revise further. The RBA should instead rely on more recent experience which shows little or no wage pressure with recent low unemployment rates.
In short, the present degree of tightness in the labour market does not present a risk of higher inflation if interest rates start to come down.
Furthermore, returning to the outlook for price inflation, it is important to note that the rate of inflation has been coming down faster in the last six months. Thus, over the last six months the underlying rate of inflation (the trimmed mean) was running at an annual rate of only 2.6% – well within the RBA target range.
Furthermore, because the increase in prices for the March quarter 2024 will drop out, the next increase in the trimmed mean for the four quarters ending in March 2025 will almost certainly be within the RBA target range and the RBA Board should allow for that when it next meets in the middle of February.
In addition, we all know that monetary policy only acts with a lag. If the RBA wants to stay on its “narrow path” and avoid a recession, then it needs to anticipate when inflation will be back in its target range and start lowering interest rates a bit in advance. So given the confidence that annual inflation as measured by the trimmed mean will be back in its target range this current quarter, the RBA should start to lower interest rates at its next February meeting.
Indeed, that is what financial markets are already expecting, and it is why as far back as last September I concluded that the RBA should cut interest rates that year, and no later than last December.
Cost of living
The most important issue for most Australians right now is the cost of living, and a cut in interest rates will make a substantial difference to the cost of living for a large part of the one-third of all households which have a mortgage.
The latest available data (September quarter 2024) show that since the Labor Government was elected real wages have fallen by 0.9% – not a lot, and over the last year to the September quarter 2024, real wages actually increased by 1.2%.
But over the longer period from December quarter 2019 to September quarter 2024 real wages fell by as much as 4.2%. In other words, peoples living standards are typically lower than they were pre-Covid, but most of that fall occurred during the Morrison Government.
Where the Albanese Government might be held to blame is the impact of interest rate increases on the cost of living, as these only started just before the Albanese Government was elected and all but the first interest rate increase has been since that election.
In fact, interest rates are not included in the ABS measure of consumer prices, and they therefore are not reflected in the measure of real wages cited above. Thus, those households with a mortgage – about one third of all households – will have experienced the greatest increase in their cost of living since the election of the Albanese Government.
On the other hand, the counterpart is that if interest rates now start to fall, those households with a mortgage will experience the greatest cost of living relief. For example, a household with a typical $600,000 mortgage, a one quarter percentage point cut in the interest rate would deliver a saving of $100 on monthly repayments.
Conclusion
The available evidence strongly supports the conclusion that it is time for the Reserve Bank to start cutting interest rates. That would help avoid any recession as well as helping reduce the cost of living for the one third of households with a mortgage.
But restoring peoples’ expectations for ongoing increases in living standards must depend upon an increase in productivity. That will be more difficult as with the exception of the US no other developed country has increased its productivity significantly during the last decade, and we don’t really understand why not.