Is the economy slowing fast enough?

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The data says the RBA has more work to do

The June quarter national accounts suggest demand is slowing, but not fast enough to bring inflation back to target in a reasonable timeframe. GDP increased by 0.4% in the quarter, while annual growth slowed from 2.5% to 2.1%. Yet weak productivity growth continues to constrain the economy's supply side, meaning capacity pressures remain persistent. Coming on top of last week's stronger-than-expected inflation print, the national accounts strengthen the case for further policy tightening. We now expect the RBA to increase the cash rate by 25 basis points when they meet on 28-29 September.

Rates are biting, but why is demand resilient? 

Higher interest rates are weighing on the economy. The housing market is correcting, mortgage lending has slowed and labour market conditions are no longer as tight as they were a year ago. But these indicators tend to lead broader developments in the economy, and the national accounts suggest higher interest rates are yet to translate into a meaningful slowdown in demand. June quarter growth was broad based across household spending, dwelling and non-residential construction, government demand and exports. There was little evidence that weakness in any one part of the economy was dragging materially on overall activity. Investment in data centres did fall in June after surging in the March quarter, but we expect projects to be lumpy. Had data centre investment continued to expand, overall GDP would have been stronger still.

So why has demand remained so resilient? We have previously flagged the strength of household spending as somewhat puzzling given the pressure on household finances from rising prices and interest rates. The surprise revealed in the national accounts was not that consumers continued to spend, but that real disposable incomes still grew by 0.6% in the quarter, despite these headwinds. 

Labour incomes are robust

Crucially, this does not mean higher interest rates aren’t restraining household finances. Rising mortgage rates are hurting disposable incomes. Rather, the drag from higher interest costs is being offset by continued strength in labour income growth. Compensation of employees, the broadest measure of wages and salaries in the economy, continues to grow at an annual rate of over 6% and has shown little sign of slowing. That reflects ongoing growth in both employment and wages. While the labour market has eased, strong growth in labour income continues to support household spending and helps explain why demand has remained more resilient than expected.
 

 

While the labour market has eased, strong growth in labour income continues to support household spending.

 

While the strength in labour income supports household spending and helps sustain economic growth, it also contributes to inflation persistence. The same wage growth that is supporting household incomes is also increasing labour costs for businesses. With productivity growth remaining weak, the higher labour costs are not being offset by stronger output, contributing to a reacceleration in unit labour costs and increasing the risk that businesses pass higher costs on to consumers. Indeed, unit labour cost growth reaccelerated to 3.6% over the year to June, a pace inconsistent with inflation returning sustainably to target.

A supply side that cannot keep up

The national accounts highlight that the challenge in managing the economy is not simply to slow demand. The economy's capacity to grow remains constrained, reflecting several years of weak productivity growth. This means inflation can persist even when growth appears modest by historical standards. As a result, even what we would typically consider to be below-trend demand growth, as we saw in the June quarter, may be too strong to return inflation to target. 

 

Even below-trend demand growth may be too strong to return inflation to target.

 

While domestic inflation pressures are the primary reason for our revised interest-rate forecast, the global backdrop is also turning less favourable. Escalating tensions in the Middle East have pushed oil prices higher, with Brent back up to US$95/bbl, further increasing the risk that the conflict shifts toward our Malign or Malignant scenarios. These scenarios both lift inflation and interest rates as higher energy prices are passed through supply chains.

The case for tightening is clear, the question is when?

The case for further tightening already appears sufficiently clear. The national accounts suggest demand is slowing only gradually despite restrictive financial conditions, while last week's CPI showed services inflation lifting further in July. Taken together, the data suggest inflation is unlikely to return to target within a reasonable timeframe without additional policy tightening.

The key question then becomes around timing rather than direction. Waiting until November would provide the Board with another quarterly inflation report and updated forecasts. For us, the one-two punch from the national accounts and the CPI suggest there is no need to wait for more data. Demand is slowing, but not fast enough.

 

Demand is slowing, but not fast enough.