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Key Points:
- The economic outlook remains particularly divergent by sector, reflecting the negative influences of higher interest rates and oil prices, and general wage and cost pressures on the one hand, but also the positive effects of strength in AI, defence and renewables investment on the other.
- Central banks are trying to balance these divergent influences, importantly from above-target inflation starting points. It seems likely that monetary policy will be tightened in both Australia and the US before the end of the year.
- Businesses should allow for the possibility of a further increase in interest rates in the next three months as cost increases and price rises continue to run too quickly, relative to the RBA’s inflation target. The RBA needs to constrain economic growth and loosen the labour market to sustainably deliver more moderate inflation.
RBA on hold in August but remains on high alert on inflation
The RBA Board voted unanimously to leave the official cash rate unchanged at 4.35% at its August Board Meeting. However, the accompanying communications highlighted ongoing upside risks to inflation and noted that demand growth will need to remain subdued in the months ahead to support inflation returning to the target 2.5% midpoint. Unlike its June meeting, the Board considered a rate increase in August. However, after raising interest rates three times during the first half of the year, the RBA is currently assessing the effects of these rate rises on economic activity and inflation, given monetary policy take time to flow through to activity.
Often, when the Board discusses upside (or downside) risks to the economy or inflation, it will tend to act on these concerns within a three month period. This suggests the next two meetings could see a possible further increase in Australian interest rates.
There is currently an unusual divergence in the views of Australian market economists. Many commentators suggest interest rates have already peaked and will decline modestly next year, while others are still forecasting further tightening will be required to return inflation to target. My expectation remains that some further modest tightening will be required, with interest rate cuts seeming unlikely over the next 12 to 18 months.
US Federal Reserve continues to warn on inflation
The US Federal Reserve also remains concerned about inflation. New Chair, Kevin Warsh, signalled strongly during his first press conference that, after an extended period of failing to achieve its inflation target, the Fed will deliver prices stability (in the US that’s a slightly lower 2% inflation target than in Australia). For now, the Fed remains in an active watching phase, assessing developments in the economy and inflation, and considering the policy settings required to bring inflation back to its target.
Some tightening of US monetary policy before the end of the year also seems highly likely. This is usually important for medium to longer-term Australian borrowing rates, given the close correlation between their movements. This correlation has slightly weakened in recent times as RBA and Federal Reserve monetary policies have somewhat diverged, with the RBA raising interest rates three times in the first half of the year, while the Federal Reserve left its interest rates unchanged. Even so, US swap rates have risen this year as markets reflect the risk of US rate rises.
Economic and interest rate outlook
The outlook for the Australian economy remains mixed across sectors. Macroeconomic factors include recent interest rate and in oil price rises, and persistently high cost and wage inflation. The latter includes the Fair Work Commission’s recent higher-than-expected 4.8% award wage increase.
Higher interest rates and oil prices are placing pressure on the discretionary, interest sensitive and industrial sectors of the economy. Businesses across Retail, Recreation Personal Services and Manufacturing have reported slightly weaker business conditions in recent months. At the same time, the spill-over effects from the AI, renewables and defence spending booms are providing important support for the overall economy and especially benefiting selected parts of the Mining and Construction sectors.
This is the divergent economic and inflation environment both the RBA and the US Federal Reserve are currently managing, assessing and trying to balance. AI investment is driving more traditional demand-driven inflation in technology components, selected metals, electricity and water, while oil prices are another example of a supply-driven inflation shock, with the added complication that the latter may prove temporary or escalate sharply.
Importantly, current inflation rates in both Australia and the US remain above target, meaning at the very least, an early reduction in interest rates is unlikely to be possible. More likely, some further tightening in monetary policy will be implemented in both countries over the next three months. Furthermore, the RBA has indicated that it is not particularly concerned about recent house price declines at this stage, noting how significantly house prices rose over the COVID period.
What it means for your business
The outlook for the economy remains unusually divergent by sector at the present time, providing opportunities for some businesses but challenges for others.
Businesses should allow for the possibility of a further increase in interest rates in the next three months as cost increases and price rises continue to run too quickly, relative to the RBA’s inflation target. The RBA needs to constrain economic growth and loosen the labour market to sustainably deliver more moderate inflation.
Real Estate is a sector that is likely to be under additional pressure in coming months, with housing turnover and prices softening in the wake of interest rate increases in the first half of the year and the changes announced to taxation affecting housing in the May Budget. While this may present opportunities for those with cash, it may also constrain the amount banks may lend, given many smaller businesses use their homes as collateral for loans.
