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Slowing wages offer hope for lower rates
In last week’s Brief, we previewed our expectations for Australia’s GDP data, forecasting growth of just 0.1% in the March quarter, slightly below economist forecasts of 0.2%. In line with our forecasts, GDP growth indeed slowed to a mere 10 basis points in the March quarter, with the economy perilously close to stalling or even slipping backward. The GDP data show the impact high interest rates are having on industries. Tight monetary policy works through a number of mechanisms, including increasing the cost of capital and the incentive to save rather than spend (the saving and investment channel), and reducing the amount of cash households and businesses have available to spend (the cash flow channel).
The increased cost of capital is having a dampening impact on the construction industry, where output fell by 0.2% in the year to March, compared to 1.1% growth across the whole economy. Both residential and non-residential, and private and public sector construction fell in the March quarter. Residential construction has been particularly weak, with industry profitability falling due to rising construction costs (input and interest costs) and labour shortages. This is leading to an increase in bankruptcies. These supply problems mean that the construction pipeline will be slow to respond to the strong demand for housing that is pressuring house prices ever higher. CoreLogic data, released earlier this week, showed house prices rose by 0.8% over the month of May, and by 9% in the last year.
The cash flow channel of monetary policy is working through its impact on households’ real disposable incomes. Continued growth in labour income is being offset by the impact of higher interest payments on debt, which rose by 3.2% in the March quarter and 30% over the last year.
Weaker disposable incomes force households to cut back on discretionary items, like clothing and footwear, holidays and eating out; spending on discretionary items has been flat over the last year. In contrast, households have tried to maintain spending on essential items such as food, electricity, insurance, health and education. Spending on essential items grew by 2.1% over the year, but still fell in per capita terms.
The accommodation and food services industry has been hard hit by the reduction in discretionary spending, with the industry contracting by 3.0% in the year to March. Retail trade has also suffered from the drop in discretionary spending, contracting by 0.2% over the year. Consequently, inflation is slowing sharply for discretionary goods and services. Annual inflation rates are down to just 0.2% in the recreation and culture sector, while inflation rates for clothing and footwear and goods sold by department stores fell to 0.4% and 0.7% respectively.
Monetary policy is clearly having its desired effect on the prices of discretionary items. So why isn’t aggregate inflation falling faster?
The answer lies in the 4%+ inflation being recorded for essential items, for which the RBA can exert little influence. Housing continues to put upward pressure on inflation, particularly via rental costs, and the supply problems in the construction industry mean this is likely to be persistent. In this context, fiscal policy is playing an important role to help alleviate some of the pressure on housing inflation, via the government’s rental and electricity subsidies.
Inflation in health and education is running above target and insurance premiums are rising strongly as they adjust to higher costs of the underlying assets and increased risk. And while fresh food prices have eased due to favourable growing conditions, processed foods and takeaways have remained more robust.
While there are differences, common across industries and critical to the inflation outlook is the cost of labour after adjusting for productivity; that is, unit labour costs. Unit labour costs have been growing at rates that are unsustainable and far in excess of the RBA’s inflation target. But the good news is that unit labour costs slowed to a more sustainable rate of 0.4% growth in the March quarter, due to a combination of slower wage growth and a modest recovery in measured productivity. This comes after the March quarter annual wage inflation fell to 4.1% from 4.2% and is consistent with the outlook for slowing wage growth.
However, the prevalence of enterprise bargaining arrangements and awards in wage setting behaviour means wages are relatively slow moving in Australia. Earlier this week, the Fair Work Commission (FWC) announced its annual wage review for minimum and award rates of pay. With the labour market remaining tighter than pre-COVID, and with inflation above target, unions sought a 5% wage increase. Business groups had suggested something closer to 2% was appropriate given the weakness in business conditions and the elevated growth of unit labour costs.
Ultimately, the FWC decided on a 3.75% rise across both minimum and award wages starting from 1 July, which is significantly lower than the 5.75% adjustment in the previous year. In bringing down its decision, the FWC cited uncertainty over the outlook for productivity and the weakness in the retail trade and accommodation & food services industries, which are heavily reliant on award labour, as reasons for the lower wage outcomes than last year.
Slower growth in minimum and award wages will help ease pressure on inflation. Responsible economic management across monetary and fiscal policy, as well as businesses and unions, helps contribute to the likelihood of achieving lower inflation outcomes without pushing the economy into recession. We remain of the view that the RBA should be able to begin a mild rate cutting cycle toward the end of this year.