RBA optimism on the economic outlook to be tested

The RBA’s “narrow [economic] path” has involved raising rates by less than other countries as it aims to limit the increase in unemployment as inflation returns to target by 2026. Recent data suggest that this optimistic outlook will be tested by underlying inflation again exceeding the RBA’s forecast profile in Q2, where history suggests that falling inflation typically coincides with unemployment exceeding the estimated NAIRU.

The RBA next meets on 5-6 August and seems likely to raise the cash rate if underlying inflation again exceeds its forecast profile when the Q2 CPI is released at the end of July.

The monthly CPI is more limited in scope than the quarterly CPI, but it suggests that trimmed mean inflation could print at either 1.0 or 1.1% in Q2, above the RBA’s forecast of a 0.8% quarterly increase.

Deputy Governor Hauser recently downplayed this risk, arguing that, “it would be a bad mistake to set … policy on the basis of one [monthly inflation] number and we don’t intend [to] do that”.

However, this was a somewhat misleading argument, in that if inflation is above the RBA’s forecast in Q2, it would mark the third time in the past four quarters that this had happened, raising questions about whether inflation will return to target by mid 2026.

The deputy governor also pointed out that, “there is a whole series of data coming out between now and when we meet in August”, namely the Q2 CPI, two retail sales reports, business surveys and an “important release on employment”.

The important release on employment is the June labour force survey, which is due Thursday, where the market expects the unemployment rate will edge above 4%.

The labour force survey is always volatile, but the numbers have become more noisy in the wake of COVID because the seasonal adjustment of the data has been distorted by shifts in hiring patterns.

In broad terms, though, the unemployment rate has increased from a low of around 3½% in late 2022 to about 4%, driven by strong employment growth failing to keep pace with a surge in the workforce post the opening of the international border.

Weekly payroll data suggest employment could be weak in June, although the Beveridge curve relationship between job vacancies and unemployment suggests that there is still capacity for firms to scale back on the demand for labour by reducing vacancies rather than staff.

Aside from cutting job vacancies, the other way firms have adjusted their demand for labour has been to alter hours worked, which are much more volatile than employment and have barely grown over the past year.

The RBA focuses on hours worked when analysing labour productivity, but bank staff also monitor a version of the unemployment rate based on the hours that employees and the unemployed would like to work.

Like most labour market indicators, the hours-based unemployment rate is highly correlated with the traditional unemployment rate, but provides a bit more colour on spare capacity, where Australia is different to most countries because of the large number of part-time workers.

On CCI’s calculation, the quarterly hours-based unemployment rate has increased from a low of 4½% in late 2022 to 5¼% in Q2 this year, which is a slightly larger increase than in the standard unemployment rate.

The two unemployment rates suggest that there is still excess demand in the labour market because they are below their respective NAIRUs, more so for the hours-based unemployment rate.

• The usual unemployment rate of 4% is nearing the 4.3% NAIRU as recently cited by Governor Bullock, which is at the low end of the 4¼ to 5¼% range for NAIRU calculated by RBA staff.
  
• The hours-based unemployment rate of 5¼% has further to rise before it reaches the RBA staff’s 6 to 7¼% range for the hours-based NAIRU.
  

The RBA is forecasting that both measures of unemployment will rise further, but not by much, with unemployment forecast to broadly peak either at or near the low end of estimated ranges for the respective NAIRUs, which in turn is well below pre-pandemic levels.

Such a benign outcome could be achieved for a time if job vacancies and hours worked continue to bear the brunt of the adjustment in the labour market, but the risk is that unemployment rises more sharply once vacancies are back at pre-COVID levels.

Put another way, history shows that both measures of unemployment rarely spend any time near the estimated NAIRU, and that falling inflation is normally associated with both measures of unemployment exceeding the midpoint of the RBA ranges for the respective NAIRUs.