Economic pulse check
Economic pulse check
Almost 4 months have passed since interest rates began to rise and while home prices have been quick to fall, and consumer confidence has faded, the economy entered this tightening cycle with strong momentum. The labour market is tight, but wages have been slow to pick up.
With many forecasters predicting a terminal cash rate target of plus 3%, we take a look at the current state of play and what it could mean for buyers and sellers.
Wages
Despite anecdotal evidence of stronger wages growth, the Australian Bureau of Statistics Wage Price Index (WPI) has shown wages, although moving higher, for most of the workforce are only doing so at a moderate pace. Unlike other developed economies, there is no breakout.
The Q2 data released this week show there are some signs this could change later this year, with the average pay rise given to private sector workers over the quarter reaching 3.8%.
Relative to most of the prior decade the release shows some strength, but it’s a low bar, and given inflation pressures, the fast pace of rate rises, and unambiguously tight labour market are disappointing for workers.
The WPI strips out compositional changes in the labour force and changes in the number of hours worked to provide a measure of pure wage inflation. The slow rise is a nod to sticky wage settings, and illustrates the large number of workers on enterprise bargaining or multi-year agreements, which time to renegotiate.
Wages growth is the number one determinant of sustained inflationary pressures and this week the Q2 update showed the WPI rose by 0.7% QoQ in Q2 with the annual rate increasing to 2.6% from 2.4% in Q1. Despite the uptick, neither the three (2.90%) or six month (2.76%) annualised pace of wages growth is above 3%. 
Including bonuses, the measure has ticked just above 3%, showing that employers are choosing to hand out bonuses over locking in long term higher pay rates.
The latest WPI figures also show real wages growth is at its lowest level since comparable records began in the 1990s. Looking at wages in inflation adjusted terms is important in gauging what is currently a very steep decline in purchasing power for households.
There is some evidence of stronger wage increases, though it is not broad based. For those private sector jobs that did receive a pay increase, the average increase was 3.8% in the June quarter, the highest increase recorded since June 2012.
This bears watching next quarter given the September quarter typically sees a larger proportion of pay increases.
Labour market
The labour market remains tight and this week the latest labour force survey shows that in July the unemployment rate fell to 3.4% - the lowest since September 1974. Though this fall from 3.5% in June was driven by a drop in participation.
The underutilisation rate and underemployment rate continue to lower, both measures of spare capacity in the labour force, with stronger linkages to wages growth. The underutlisation rate which refers to people who are either unemployed or looking for more hours of work has fallen sharply, to levels last seen in the 80s.
Inflation
Inflation has surged with supply chain disruptions, higher fuel prices and floods pushing food prices higher.
Though there are signs that inflation pressures could be set to ease off, as freight costs and supply chain disruptions are reversing, while oil and other commodity prices have fallen. Data released from China this week, the world’s factory gate, showed producer prices tumbling. And excess inventories at retailers who over-anticipated the demand pulse are likely to combine to reduce pressure on core goods prices later this year.
Australia’s consumer inflation expectations in August show expectations easing to now sit at 5.9% (vs. prior 6.3%).
RBA minutes
This week the Reserve Bank released the minutes of its August meeting. Providing insights into the RBA’s decision at the meeting to raise rates by 0.5 percentage points, bringing the cash rate to 1.85%.
The minutes, in keeping with the statement, suggest an element of caution with a nod to economic conditions as well as inflationary pressures. The RBA reiterated its data dependent stance flagged in the statement, with no “pre-set path” for further tightening.
The RBA again highlighted the “narrow path” and unenviable task of keeping the economy on an “even keel” whilst returning inflation to its 2-3% target range
The language perhaps an indication of a shift back to a more measured pace of tightening with a return to “business as usual” (25bp) rate rises coming sooner rather than later.
With respect to data dependency, the wages data and the labour force survey released this week have not provided a clean-cut trigger for another 50-basis point hike in September. It’s quite possible the RBA will opt for a less aggressive 40bp increase to return the target to a conventional step point, signaling that the return to “business as usual” (25bp) rate rises is not far off.
Interest rates – a pause in sight?
A spending slowdown is inevitable with household budgets under pressure as the cost of living has risen. The big question is how much household spending slows with higher inflation, higher interest rates and falling house prices (the negative wealth effect), against the backdrop of savings and wealth buffers, a tight labour market and hopefully stronger wages growth.
How these factor interplay will be crucial in determining the loss of conditions in the economy and as a result how high and fast the cash rate rises.
In many developed economies recession is a growing risk. The US is already in a technical recession (two consecutive quarters of negative growth), and weak China growth, Euro zone frailty and a looming pullback in the British economy all spell potential for a global recession.
With easing inflation pressures into year-end, it’s looking more likely that rates could peak towards the lower end of the range of forecasts.
Interest rates are likely to keep rising, but at a slower pace, to levels in line with the lower end of the RBA’s estimated 2.5-3.5% neutral range, as the year ends.
So, what could all this mean for mortgage holders?
The cost of servicing a mortgage will continue to increase, but if the cash rate were to climb to 3% (implying a variable mortgage rate above 6%) that would mean even more pressure on households, so a pause ahead of 3% could be welcome relief.
And for Buyers?
As interest rates continue to climb, borrowing capacities will be further constrained. As the cash rate moves above 2%, and that is passed through to mortgage rates, maximum borrowing capacities will be constrained by close to 20%, meaning many potential buyers' budgets will shrink.
And lastly for sellers?
For those looking to sell it’s not such good news, with price expectations dropping and properties taking longer to sell with fewer competing bidders. With maximum borrowing capacities shrinking and repayments sharply rising, downward pressure on house prices will remain.
** Article written by Eleanor Creagh, Senior Economist, REA Group
