Introduction
The RBA has a dual mandate to target low / stable inflation and full employment. Rather than target one objective (i.e. only inflation or only employment), the Reserve Bank of Australia (RBA) must attempt to achieve both in balance. It’s no wonder then that developments in the labour market are closely observed. The inflation data tends to steal the headlines because it’s much easier to report and summarise – there’s only one number. The labour market is a little trickier since it cannot be summarised quite so simply. However, there have been very interesting trends emerging in the Australian labour market of late which imply that cuts in interest rates are not imminent.
But taking a step back, let’s first explore how monetary policy works, why it is relevant now, and how the RBA uses a range of indicators to set interest rates.
Monetary Policy in Action
Monetary policy is a key pillar of Australia’s financial system. Monetary policy is enacted by the RBA and primarily involves setting a target for the interest rate on overnight loans in the interbank market – better known as the cash rate. The cash rate greatly influences other interest rates in the economy, which in turn affects wider economic activity and the behaviour of individual households and businesses. Monetary policy, and specifically the cash rate, has been very topical over the past two years given the emergence of inflation after a long hibernation. The RBA increased the cash rate from 0.10% to 4.35% to help bring aggregate demand and aggregate supply into better balance. But as we’ve seen from continued inflation prints, the battle is far from over.
What is ‘the data’ that the RBA refers to?
The RBA has indicated that the path of interest rates depends on the data – but what data are they referring to?
The Australian Bureau of Statistics releases a broad range of economic data on a monthly and quarterly basis including releases on GDP, inflation, trade, labour force and unemployment, business indicators, and household incomes. The RBA uses all this data – and more – to analyse the economy. The other places the RBA sources data are from APRA, from the larger banks, and from business directly via the business liaison program.
From the RBA’s perspective (and the market too as a matter of fact), this data helps them determine how the Australian economy is performing at present and from there, how it might be expected to perform in the near future. But the big fish for the RBA is that this array of data helps establish their current and forthcoming assessment of inflation. Using a simplistic example, strong data (eg. a low unemployment rate) generally creates inflationary conditions because, broadly speaking, households are employed, earning income, and spending on goods and services. If the data is weak (eg. high unemployment), this is not conducive to an inflationary environment since people are not working, not spending, and will generally be saving money for a rainy day. From there, the RBA can either adjust or maintain the cash rate based on the prevailing conditions.
So, what is happening in Australia?
Last week, the Australian Labour Force report showed the unemployment rate at 3.8% in March. Although this was 0.1 percentage points higher than the result in February, it was lower than the consensus expectation of 3.9%. In the context of the RBA, it is useful to look back a few years as this helps paint a bigger picture.
Source:
ABS, FIIG Securities.
The unemployment rate hit a historic low of 3.5% in 2022
following the pandemic, at which time inflation was around 5.1% and much higher
than the RBA’s target of 2-3%. The reason is fairly logical and one we’ve all
heard before: more jobs and less labour supply (as borders were closed), plus
large amounts of stimulus, meant more spending and higher inflation. The RBA then
began its rate hiking cycle to help reduce inflationary pressures.
Theoretically, when interest rates rise, or remain elevated for as long as they
have, we should see a softening in employment (i.e. higher unemployment). Indeed,
this is what most economists predicted, and in early 2024, economists argued
that the underlying trends indicated that the start of the uptick in
unemployment had begun and would persist.
But this has not happened. The unemployment rate still sits
at a historically low level, and now, economists are questioning which trend is
taking over? Is there still a slow softening in the labour market, or is the
trend now a sideways one?
Source:
ABS, FIIG Securities.
Following the March labour force report last week, the
market and economists have come to conclude that (rather unsurprisingly) the
Australian labour market is still tight and that the latter trend, being the
sideways one, is the new normal.
But what are the implications for inflation? If we link this
back to our example, more people in jobs means that the demand for labour is
high. This is slightly inflationary in its own right, since it suggests
producers are incentivised to pay more for labour and raise their selling
prices to do so. But more importantly, economy-wide, it suggests that any
increase in demand for labour could not be met without material wage increases,
and wage increases mean rising, or sticky, inflation. If inflation remains
above the RBA’s 2-3% inflation target while the unemployment rate is trending
sideways, the argument for RBA rate cuts becomes exceptionally weak. It makes
sense then that the market is no longer pricing in a rate cut in 2024.
Conclusion:
The RBA keeps an eye on the Australian labour market as it
is one of the most important indicators of the growth of the economy. Labour
data is a direct target of monetary policy via the RBA’s employment mandate,
but also an indirect one since it so clearly affects inflation dynamics. Over
the last six months or so, the unemployment rate has trended sideways and still
remains at extremely strong levels. While the unemployment rate remains low and
inflation is elevated, there is little reason for the RBA to cut interest rates.
But as a central banker would say, it all depends on the
upcoming data – and the next big one is the inflation scheduled for 24 April.