Asset Allocation Strategy
5 February 2024
Australia Back on the Lower Inflation Track
Encouraging Trends in Quarterly CPI

Australia’s headline CPI rose by 0.6% in the fourth quarter (4.1% p.a.), below consensus expectations of a 0.8% increase. 

The RBA’s preferred underlying inflation (the trimmed mean) came in a touch below expectations at 0.8%. The year on year measure now sits at 4.3% p.a., below the RBA’s most recent (November) forecast of 4.5% but still well above the RBA’s 2-3% target. 

While inflation is still too high, this inflation result is a welcome outcome after many quarters of very high inflation and the previous quarter’s upside surprise. 

Figure 1: Australian headline inflation looks to be in an established downtrend
Figure 2: The RBA's preferred core measure is also coming back under control


Better Inflation Trends in the Fourth Quarter - The Details

The main areas still making a significant contribution to above average inflation are meals out and takeaways, rents, utilities, insurance and financial services, and healthcare.

Areas now showing encouraging disinflation trends are food (ex-takeaway), clothing and footwear, furnishings and household equipment, as well as recreation and culture.

Figure 3: Pressure is easing in most categories albeit more progress is needed in key areas, such as housing

It is notable that government initiatives have reduced prices or slowed increases in some key CPI categories, although some policies have added to inflation (e.g. tobacco excise indexation). On balance we estimate that government subsidies and rebates (across both the Australian and state governments) have materially lowered 'measured' inflation, most particularly rental assistance and electricity rebates.

Looking forward, if these subsidies were to expire, there would be a large potential increase in measured inflation over the coming year. However, it now seems increasingly likely, based on Australian Government Treasurer comments, there will be an extension of at least some of these 'cost of living' support measures announced at the May budget.


The Good, the Bad and the Ugly

Australia’s headline inflation rate peaked at 7.8% in the fourth quarter of 2022. The slowdown to 4.1% since then mainly reflects lower food, housing, transport and recreation costs, albeit housing costs continue to run well above average levels.

Figure 4: Tradable goods inflation has collapsed from Peak (Dec 2022) levels, but many services areas remain high

Overall, the moderation of global inflation appears to be finally flowing into Australia, albeit domestic inflation trends remain relatively sticky, and broadly consistent with RBA Governor Bullock's recent discussion of 'home-grown inflation'.

Figure 5: Australia has lagged the global downtrend but we are now making decent progress

Specifically, tradeables CPI (globally driven) moderated to -0.7% quarter on quarter (after +0.7%), while the year on year dropped sharply to 1.5% (after 3.7%). 

Non-tradables inflation (domestically driven) remains sticky at 1.3% quarter on quarter and 5.4% year on year. In a similar vein the services measure (driven more by domestic labour costs) stayed elevated at 1.0% quarter on quarter and 4.6% year on year (after 5.8%). Slower consumer spending should help ease non-tradables/services driven inflation; however, the RBA will be monitoring wage outcomes this year very closely.

A key sticking point for inflation remains the key housing component, which makes up 22% of the CPI and is still growing at 6.1% year on year. New dwelling cost growth is easing, but relatively slowly. Rents are still growing at a brisk pace, though closer to 7% than 10%. As discussed utilities are being held down by subsidies that will be reviewed later this year. 


Better (But Still High) Inflation and the Monetary Policy Outlook

While these latest figures are encouraging, Australian headline and underlying CPI growth continues to run well above the RBA target zone, so the RBA will not be in a huge hurry to cut rates. 

The RBA will remain somewhat concerned at the still high rates of growth in services prices, and the concentration of price pressures on the domestic (non-tradables) side of the economy. 

Nevertheless, the improved CPI trajectory should almost certainly allow RBA Governor Bullock to call time on the tightening cycle and ultimately deliver rate cuts, albeit not until the second half of this year. 

Figure 6: The interest rate market is now pricing two cuts in the second half of this year

The market now has the cash rate priced for 3.85%, or two cuts by the end of 2024, with the first likely around August. This seems a reasonable expectation to us. We still expect the pace of cuts to remain relatively slow in comparison to the Fed, with only two RBA cuts this year to bring the cash rate to 3.85% and to ~3% by end-2025. 

The economy is likely entering at least a first-half soft patch as interest rates bite and continued inflation in many non-discretionary areas pressure household budgets. Evidence the labour market is softening is also building. While this raises risk of a self-feeding slump in activity, softer demand is a positive story for the inflation outlook over the next six months. 

We see enough government-related support in prospect for the economy to avoid an outright contraction as we move through the year, with better growth likely in the second half.

Economic (and wages) growth will be supported by 1) strong public demand; 2) large increases in regulated award/minimum wages and public sector wages; 3) moderate fiscal stimulus in the Australian Government Budget due in May 2024; 4) scheduled $20bn+ (~0.75% of nominal GDP) in household tax cuts from July 2024. These tax cuts are also now set to become more skewed towards lower incomes with a higher propensity to spend. 

Hence, there is likely to be a limit to how much and how quickly the RBA is likely to cut rates in 2024 and in 2025. We expect Australia to lag other central banks in terms of timing and magnitude. 

The net stimulus in the May budget and 1 July tax cuts plus likely significant regulated wage increases on 30 June all make a June start for rate cuts unlikely in our view. As a result, the RBA is unlikely to signal for near-term cuts at the upcoming February policy statement. 

All things equal, a relatively patient and gradual policy easing should be ultimately positive for the A$ (on a 6- to 12-month view) and be supportive of moderately lower bond yields. The equity market will have to look through near-term economic softness, but the prospect of lower policy rates over the next 12 months should provide support and see the market at least moderately higher 12 months from now, absent any unduly negative global influences (not our base case).

Figure 7: RBA easing has on average been good for the Australian market, but not always
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Written by

David Cassidy, Head of Investment Strategy

David is one of Australia’s leading investment strategists.

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