The December quarter Australian CPI numbers surprised the market when they were released on Wednesday.
This print was closely watched, as it is the last full inflation print before the RBA’s Cash Rate decision on February 18th. Annual headline inflation fell to 2.4% from the September read of 2.8%, while Trimmed Mean Inflation (the RBA’s preferred measure) came in at 3.2%, down from 3.6% in September.
Key components still driving inflation are insurance and financial services, health, and housing (rents), though we have seen rental growth slow in recent quarters. The headline measure of inflation continues to be distorted by the Commonwealth Energy Bill Relief fund rebates.
Is Inflation Finally Under Control?
The market consensus was for a trimmed mean result of 0.6% q/q. However it came in cooler than expected at 0.5% q/q - a number that many economists have touted as being a material enough miss to likely trigger a Feb cut. In light of the result, a number of banks and market commentators have revised their expectations, by pulling forward their rate cut predictions to February. We think this makes sense.
The expectations of a possible rate cut in February grew through December, with soft retail spending and weak GDP growth. The market was pricing a 73% chance of a February rate cut into January. However, the labour market remained surprisingly resilient. December jobs numbers released in early January delivered a massive upside surprise. Some 56,000 jobs were added in December, against an expectation of only 12,000. This continued the trend of upside labour surprises, after November recorded 24,000 jobs. As such, market pricing expectations of a February rate cut eased through the month, sitting at ~73% following the release of the labour numbers. Immediately after the release of the December CPI print, this pricing was revised to ~95% probability of a Feb cut.
RBA’s Decision May Not Be as Easy as the Market Thinks
The dilemma that this presents for the RBA is that the labour market remains tight, despite weak GDP and leading indicators like business surveys which suggest it should have eased significantly. The unemployment rate remains at ~4%, well below the RBA’s estimate of 4.25% - 5.25% NAIRU (Non-Accelerating Inflation Rate of Unemployment – a figure policymakers use to estimate the lowest unemployment rate that can be sustained without causing wages growth and inflation to rise). There is debate about whether the true NAIRU might be lower than the RBA’s estimate, with several economists suggesting it could be closer to the current 4% level. There has been modest easing in wage inflation in recent quarters, which the RBA will be conscious of as an indication of a cooling economy.
As we have discussed previously, household spending and business investment is soft. However, employment remains robust, largely due to strong growth in public sector-related and care economy jobs across healthcare, disability support, aged care and the bureaucracy. The continued demand for labour and low unemployment rate does risk driving renewed upward pressure on wages. Further compounding this is a continued boom in government spending, which is showing no signs of abating with more stimulus flagged in the lead up to the Federal election due by May.
Australia’s population boom is underpinning GDP, albeit also adding significantly to inflation pressure. Aggregate GDP numbers remain positive, yet the record-long ‘per capita recession’ continues, with GDP per capita extending its run to seven straight negative quarters.
Governor Bullock had said the RBA board would need to see more than just a good quarterly inflation report before cutting rates. While she has not emphasised this as a precondition recently, our view has been that the RBA is in no rush to reduce rates, given the tight labour market and continued stubborn core inflation. This quarter’s better-than-feared CPI numbers and weak GDP growth do open the door for a potential rate cut in February.
Fed on Hold
This week, we also saw the January Fed meeting in the US, with the unanimous board decision to hold rates at 4.25 - 4.5%. The markets are now pricing the next US rate cut no sooner than June. Consumer Inflation for December arrived broadly in line with expectations, although strong US Jobs data spooked the markets and pushed back expectations for further rate cuts. The expected number of rate cuts through 2025 has reduced to just two (down from four only a few months ago). Proposed tariffs if enacted as policy could further stoke inflation, which may lead the Fed to continue to hold rates for longer to get inflation under control.
With this backdrop, our view for portfolio positioning is that the A$ continues to look undervalued relative to the US$. The A$ dropped to 62c against the US$ post the CPI data release. A lower rate decision from the RBA could further impact the A$ in the short term, despite the market already almost fully pricing February cut. We still believe that there is upside potential for the A$ over the medium term back to the 65-70c area however we don’t see the catalyst for a sustainable rise in the near term.
Australian bond yields have been dragged up (and more recently down) by US bonds - albeit the short end is still priced for rate cuts (being more domestically driven). We believe equities should be supported by lower policy rates. The share market reacted positively following the CPI print, rising to near record levels, and adding to positive news flow from the US which is still dominating the direction of the local market.
Our base case for Australia has been for a May rate cut, with 75bps of cuts through to the end of 2025. While we still believe that we will see at least 75bps of cuts through the year, the December CPI print has opened the door for the RBA to bring the first rate cut forward. We now think that a February kick off to the easing cycle is likely, although we think it is a closer call than the market is pricing. The prospect of 3 (or possibly 4) cuts by year end should continue to provide support to the local equity market and bond market, all things being equal.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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