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Monetary policy decision overshadowed by productivity paralysis
The Reserve Bank of Australia delivered a 25bp rate cut this week, taking the official cash rate to 3.60%. Just five weeks ago, the Bank surprised investors with its cautious data dependence when it kept interest rates on hold awaiting quarterly inflation data - despite already having data for two months of the quarter. The Bank has now cut rates by 75bps this year, as underlying inflation has declined to be within the Bank's target band of 2-3%.
This shift in monetary policy removes the brakes the central bank had been applying to the economy, and is an important reason to expect some improvement in economic activity over the year ahead.
The 75bps fall in interest rates saves a household with an average sized mortgage of $660,000 around $3,500 a year in repayments. Households with a mortgage represent around one-third of total households, and consumer spending is half of the economy, so the boost to incomes for this group will directly contribute to increased purchasing power for one sixth of the economy.
Also contributing to stronger incomes are signs of rising real wages. Data this week showed the wage price index rose by 3.4% over the year to June, well ahead of CPI inflation of 2.1%. Real wages remain below their pre-covid level, so cost-of-living pressures are still front of mind for most workers, but the slowing in inflation means the worst of the belt-tightening is now behind working households.
The ongoing resilience in the labour market is also playing a critical role in supporting household incomes. The July labour market report showed a modest fall in the unemployment rate to 4.2%, with strong gains in full-time employment and record high levels of participation in the workforce, particularly for women. The gap between male and female workforce participation has fallen to new lows as women have been encouraged to enter the labour market due to a combination of higher wages in the care sector, better access to childcare and the normalisation of working from home after the pandemic. Employment gains have provided a solid base to incomes and have prevented the cost-of-living pain becoming more wide-spread.
Improving incomes are embedded in the RBA's forecasts contained in the August Monetary Policy Statement. Their forecasts are for a gradual improvement in the economy, led by household spending and supported by ongoing public sector spending. The Bank sees inflation continuing to track close to the midpoint of the target band and the unemployment rate remaining steady around full employment. Importantly, rather than forecasting the cash rate, the Bank’s economic forecasts assume a future path for cash rates that is consistent with market pricing. Market pricing is for another cut in November, with one or two more cuts over 2026. The Bank’s economic outlook is therefore consistent with easier monetary policy.
It is a good news story for Australia, and one that would be the envy of many central banks across the world. So, it was somewhat surprising that Tuesday’s press conference took on a distinctly negative tone, driven by questions from the floor. More than half of the questions in the press conference centred on Australia's poor productivity performance. While next week's Economic Reform Roundtable, with its focus on productivity, is clearly on the minds of journalists, the main reason for the barrage of questions on productivity was the RBA's own assumption for productivity growth which was downgraded from 1.0% to 0.7% per year. Clearly the emphasis on productivity frustrated the Governor, who, in response to relentless questioning, remarked that "the main news here is actually the reduction in interest rates".
While acknowledging the adverse impact on living standards from lower assumed productivity growth, the Governor went on to explain why the change in productivity growth was not expected to impact monetary policy. The RBA assumed that economic agents were already behaving as if they knew productivity had slowed and was, therefore, already captured in the RBA’s measures of the output gap, NAIRU and the neutral interest rate. The reduction in productivity growth in their August forecasts resulted in a downward revision to potential supply that was matched by a downgrade to aggregate demand, leaving growth in the slow-lane but forecasts for inflation and the unemployment rate unchanged. Lowering their productivity assumption really just helped the RBA resolve internal tensions in their economic forecasts over the last year, which had seen them overestimating wages, consumption and GDP growth, while simultaneously getting inflation broadly right.
Slower productivity growth lowers the potential rate of economic growth in an economy and reduces the rates of return it can generate. This implies a lower neutral interest rate. The Bank’s estimates of the neutral interest rate are based on a number of statistical models and fall into a wide range of 1-4%. With the RBA forecasting economic conditions to be broadly neutral, with inflation around target and unemployment stable, we could expect interest rates to be anchored at a level that is broadly neutral. Their assumed reduction in the cash rate to around 3% certainly lies within that band.
However, the wide range of the estimate of the neutral interest rate renders it largely useless as an anchor for monetary policy. Without a strong anchor for cash rates, the RBA will be forced to remain data-dependent, putting more weight on their short-term assessment of inflation and labour market data and less weight on their forecasts and their assessment of the neutral rate. More confidence over the neutral rate, or a narrower band, would certainly give the RBA more of an anchor for the path of interest rates, and one that would be less dependent on volatile short-term data.