The new inflation figures published on Wednesday may be decisive for the Reserve Bank as it weighs a February interest rate cut.
The outcome for the December quarter is the last substantial economic update before the rate meeting on February 18, one of only two before the May deadline for a federal election.
The Albanese government is banking on rate relief before it heads to the polls, and Treasurer Jim Chalmers sounded optimistic this week.
“Australia has made substantial and sustained progress in the fight against inflation, and we expect to see that reflected in the inflation numbers,” he said on Tuesday
But while economists believe there is a good chance inflation will fall on Wednesday, it just one of three numbers the Reserve Bank is watching closely.
The other two — the jobs market and household spending — may become clearer before the following meeting in early April. Until then, will inflation be make or break?
Good news expected on inflation
The Reserve Bank’s preferred “underlying” measure of inflation was 3.5 per cent in the September quarter, and it forecasts a slight decline to 3.4 per cent in December.
But that forecast is a few months old, and most private sector forecasters with the benefit of more recent information expect something closer to 3.2-3.3 per cent.
That would bolster the prospect of a February rate cut. The main reason for the optimism is that housing costs, one of the main drivers of inflation, have eased.
Taylor Nugent, a senior economist at NAB, said the cost of building new homes likely fell in the December quarter, a “hugely important” development which wiped 0.15 percentage points off NAB’s inflation forecast.
The cost of new housing has eased, which economists expect to contribute to a low inflation result. (ABC News: Brendan Esposito)
He pointed to two causes — lower input costs, and the “fading” of the construction bottleneck that began to fuel rising prices in the pandemic.
“Housing had been a potential driver of persistence in too high inflation, but now looks supportive of further disinflation,” he said.
Mr Chalmers claimed credit for the shift on Tuesday, saying the government’s tax incentives for developers and subsidies for apprentices had made it “cheaper and easier to build houses in this country”.
“If construction costs were still rising at the rate we inherited from the Liberals, inflation would be well outside the RBA’s target band,” he said.
Mr Nugent said rents were also cooling, and that overall “underlying inflation progress looks to be substantively outpacing the RBA’s cautious November forecasts and gives the RBA the justification needed if they are inclined to cut”.
But what about the strong jobs market?
Weighing in the other direction is the sustained and surprising strength of employment numbers. Employment grew again in December, with another 56,000 jobs added, defying the expectation that higher rates would see at least modest job losses.
Mr Chalmers has celebrated the result, saying on Monday it was evidence it was possible to “make really substantial and sustained progress on inflation at the same time as we get wages up and keep unemployment remarkably low”.
But that has not been the view of the Reserve Bank, which has long said the unemployment rate would need to be closer to 4.5 per cent to be consistent with sustainably taming inflation — low by historical standards, but up from 4 per cent today.
While that does not mean the Reserve Bank will wait for that level of unemployment before it cuts rates, the continued strength may give it pause.
Mr Nugent endorsed that option, saying NAB believed there was “value in waiting to get a better handle on labour market trends” before moving and there was not “urgency” for cuts.
But Jeff Borland, labour market economist at the University of Melbourne, said in December he did not think the strong jobs market was a reason to hold off cutting rates, in part because most of the strength was coming from the public sector.
While “non-market” employment — a category that includes education, health and social care, and public administration — has been growing strongly, Professor Borland said there were signs of weakening in the private sector, showing rates were having their intended cooling effect.
“Absent strong growth in non-market employment, the labour market would have gone backward,” he said.
“Had [it] grown at the same rate as market sector employment from June 2021 onwards, total employment would have been 692,000 lower in September.”
Professor Jeff Borland said the strength in the labour market was mostly driven by the public sector and was not a reason to avoid cutting rates. (ABC News: Michael Barnett)
He said one reason for the surprising strength was that more men were finding work in the traditionally feminised health and social care sector, where male employment had grown by 50,000 since last February.
“Non-market sector employment has the special feature that it’s government funding which controls not only the amount of employment, but also the wage rate that can be paid to employees,” he said.
“For that reason, wage inflation is less impacted by employment growth than might be expected.”
The next labour market update, for the month of January, arrives on January 20, two days after the next board meeting.
Will households spend or save?
After that, the next important data release is the national accounts figures for the December quarter, due in early March.
That will offer some clarity on the final piece of the puzzle — the question of what households will do if their incomes recover as expected.
Households have been the weak spot in the economy, weighed down by the combination of rising prices and high interest rates.
A key uncertainty is whether households will spend more when their incomes recover, which may create renewed pressure on inflation, or whether they will prefer to restore their savings.
Westpac analysis of spending patterns has suggested they were more likely to do the latter with the extra money they had received from the stage 3 tax cuts. If that pattern continues and household spending is weak again in the December quarter, the case for a rate cut would be bolstered.
The Trump question
Another unknown is the economic implications of a Donald Trump presidency.
When the US dollar surged following Trump’s election, the Australian dollar slid in relative terms. While that may help the economy and the federal budget by making exports cheaper, it could also create an inflation risk including by making US imports more expensive.
But the AMP’s chief economist Shane Oliver said there was a lot of “noise” in the market reaction to Trump, pointing out that the US dollar had fallen slightly when Trump did not roll out tariffs on day one, accompanied by a slight Australian dollar recover.
“This is the way Trump does things,” he said. “We were reminded again in the last week how Trump can whipsaw markets.”
Mr Oliver said if December inflation came in slightly less than the Reserve Bank’s 3.4 per cent forecast, as AMP expects, it would be “very hard not to cut in February… The softer Australian dollar and still strong jobs market should not be barriers to this”.
