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Disappointing GDP data this week stoked speculation that the RBA will almost certainly deliver another 25bp rate cut when it next meets in July. Markets are currently factoring in a 90% probability of a 25bp rate cut in July, up from around 60% a week earlier. The economy has indeed had a weaker start to 2025 than expected. GDP hit an air pocket in the March quarter, rising by just 0.2%, down from 0.6% in the December quarter; disappointing analyst expectations for a 0.4% rise. We see competing forces in this week's data that muddy the picture for rate cuts, and provide a timely warning that, despite a robust regulatory environment and growth outlook that is the envy of the world, Australia can ill-afford policy complacency.
We see two key takeaways from the March quarter national accounts. The first is that the private sector is not yet strong enough to sustain economic growth in the face of a removal of government support. Government spending fell at its fastest rate in 8 years, and to be fair, private spending did improve, rising by 0.5%. But with household spending rising by just 0.1% in the month of April, and CAPEX expectations for the year ahead showing little real growth, it seems the economy will remain reliant on government support to stay afloat. The private sector could certainly benefit from earlier rate cuts to help smooth the transition and plug the gaps. And if monetary policy decisions came down to disappointment on economic growth, the RBA would surely be cutting rates next month. But the RBA's dual mandate covers inflation and employment, not economic growth explicitly. Typically, weak economic growth would be associated with weak employment and would translate into lower interest rates. But that is not currently the case.
This brings us to the second key takeaway from the national accounts; productivity growth has been abysmal. Despite the weak economy, employment growth has remained robust, resulting in falling labour productivity. Without an improvement in productivity, more of workers' wages get passed on as higher prices as firms attempt to maintain profitability. Higher prices lead to higher inflation and prevent the RBA from cutting rates (or at least delays monetary policy easing). The acceleration in nominal unit labour costs (the labour cost of producing a unit of output) from 4.7% to 5.1% in the March quarter is a key reason to question whether the RBA will cut rates in July, or instead wait until August when it has more data on CPI inflation.
Regardless of whether the RBA moves on policy sooner or later, the problem of poor productivity remains. Weak productivity growth weighs on living standards; GDP per capita fell in the March quarter after briefly turning positive in the December quarter. It has now fallen by 1.7% since 2022, and while only half as bad as the fall in GDP per capita during the 1990s recession, this fall in living standards has occurred despite only a modest slowdown in the economy and with a labour market that has remained robust by historical standards. Productivity growth is needed to drive improvements in living standards and grow the size of the economic pie.
Productivity growth has cyclical and structural elements. Over the last year, labour productivity has fallen by 0.9%. This is partly due to a cyclical downturn in productivity growth as firms hoarded labour during the economic downturn, but has also been exacerbated by the government-funded expansion of the care sector in recent years, which is a structural shift. This structural shift reduces measured labour productivity as the level of productivity in the care sector is a low compared to other sectors. As this structural increase in the care sector peaks and employment levels out, measured productivity will improve. The cyclical recovery in the economy we expect over the coming year will also lead to improved productivity growth. At best, rate cuts can potentially speed up the cyclical recovery at the margin by providing more stimulus to the economy.
But what of the structural element to productivity? Productivity growth has slowed since the GFC and the level of productivity currently remains stuck at 2019 levels, suggesting the structural downward trend in productivity growth may be entrenched. Turning around this structural weakness in productivity growth is a tough ask, and will take time. There is a role for government, which has elevated productivity to be a key focus of its second parliamentary term, and rightly so. Building more efficient transport networks, a skilled and adaptable workforce, and creating certainty around the energy transition are areas that the government began addressing in its first term. But these areas are costly and slow to deliver productivity benefits.
In this term, it will be critical for the government to prioritise areas that can result in more rapid gains in productivity, at the same time as strategically addressing longer term constraints
The OECD suggests that weak business investment is contributing to Australia's poor productivity performance. The OECD estimates Australia currently has a business investment gap of around 30%. Indeed, the business investment share of GDP has fallen from around 14% prior to the GFC to around 12½% currently, leaving growth in the capital stock languishing at levels typically associated with recessions. Providing tax breaks to incentivise business investment, especially for small business, could benefit productivity in the near term. It would also be well-timed given the weakness in investment intentions resulting from global trade policy uncertainty. Investment tax incentives could also be targeted toward accelerating the uptake of AI technology to reduce administrative tasks in areas such as education, health and aged care, allowing these services to be delivered more efficiently.
With cost-of-living pressures moving into the rear vision mirror, a policy pivot toward boosting productivity is clearly needed to lift living standards. While the RBA can play a minor role in boosting cyclical productivity by encouraging private sector spending, it is government policy that has to make the bigger pivot.
