Australia’s economic story enters a new chapter with the prospect of a happy ending, yet it remains a cautionary tale, writes AICD chief economist Mark Thirlwell GAICD. 

    Since exiting the pandemic, Australia’s near-term outlook has been driven by inflation and interest rates. But while that relationship has dominated the economic narrative, the precise details of the story have continued to evolve.

    At the start of the tale, as the economy emerged from COVID-19 stronger and quicker than most forecasts had expected, the focus was on the likely size and duration of a reopening inflationary shock and the speed at which the Reserve Bank of Australia (RBA) should withdraw the exceptional policy support it had previously deployed. However, as 2021 unfolded, inflationary pressures became increasingly evident across several advanced economies and the narrative started to shift from the need for policy “normalisation” to the case for policy tightening, as observers debated the extent to which inflation was a “transitory” product of post-pandemic circumstances versus a sign of more fundamental imbalances.

    The RBA’s initial approach — in line with many of its international peers — was a policy of gradualism. The central bank closed the Term Funding Facility in June 2021, started tapering bond purchases the following month, discontinued the yield target and the (now highly controversial) policy of calendar-based forward guidance in November 2021, and halted bond purchases altogether in February 2022.

    However, it wasn’t until May last year that Martin Place deployed its first increase to the cash rate target. By then, the Reserve Bank of New Zealand (October 2021), the Bank of England (December 2021), and the US Federal Reserve and the Bank of Canada (March 2022) had already delivered policy hikes. Moreover, the March quarter 2022 CPI had shown the annual (headline) inflation rate accelerating to 5.1 per cent from three per cent in Q3:2021, and an above-target 3.5 per cent in Q4:2021. By the time of May’s cash rate increase, critics were charging that the RBA had fallen “behind the curve”. And the headline inflation rate continued to accelerate — rising from 6.1 per cent in the June quarter 2022 to 7.3 per cent in Q3:2022, before hitting 7.8 per cent in the final quarter of last year, the highest rate since 1990.

    The central bank’s response involved what would become the most brutal tightening cycle during the inflation-targeting era, with the RBA delivering a cumulative 350bp of tightening over 10 consecutive meetings between May 2022 and March 2023.

    This aggressive response moved the policy debate to a new phase. Martin Place had now made it clear it was determined to bring inflation under control. What was less clear was the associated economic cost. Critics worried that because, in their view, the central bank had been slow to respond, it might now have to push the economy into recession and drive up the unemployment rate to return inflation to target.

    RBA Governor Philip Lowe acknowledged the risks involved, but committed the central bank to navigating a narrow path between recession and excess inflation, while also trying to minimise any labour market fallout.

    The plot thickens

    Now, the story has changed again. The headline inflation rate has fallen from its December 2022 peak, first dropping to seven per cent in the first quarter of this year and then falling to six per cent in the June quarter 2023. Underlying inflation has also eased, albeit more gradually. Moderating price pressures — along with emerging weakness in household spending — have seen monetary policy downshift.

    The RBA paused in its tightening cycle for the first time in April this year, and over the five meetings to August 2023 has “only” delivered a further 50bp of cumulative tightening, with back-to-back pauses in July and August. By the aftermath of August’s pause, markets and economists were speculating that there might be no more rate hikes to come.

    To date, disinflation has happened against the backdrop of an economy that has kept growing — if at a slower pace — and with an unemployment rate that stood at a remarkable 3.5 per cent as of June this year. At the end of the RBA’s narrow path, it seems that a soft landing has appeared.

    Of course, we’re not there yet. Inflation remains well above target and the RBA may yet feel compelled to take out more policy insurance. Even if it does not, the economy in general — and Australian households in particular — are yet to feel the full impact of 400bp of interest rate rises.

    Meanwhile, according to the August 2023 Statement on Monetary Policy (SMP), the RBA thinks headline inflation will have fallen to 4.25 per cent by the December quarter of this year and will end next year at 3.25 per cent. By June quarter 2025, inflation is predicted to have eased further to three per cent, and by December quarter 2025, is expected to be back within the target band at 2.75 per cent. The corresponding projections for underlying inflation see it falling from four per cent in December quarter 2023 to 2.75 per cent by December quarter 2025.

    The SMP says the cost of returning inflation to target — even in this relatively gradual manner — is a prolonged period of below-trend activity and a “per capita” recession, with year-average real GDP growth expected to be just one per cent across 2023–24 and 1.75 per cent in 2024–25. Even so, the associated labour market cost is thought to be modest. The unemployment rate is forecast to climb to four per cent this year and peak at 4.5 per cent by the December quarter of 2024, where it is expected to remain until end-2025. By comparison, the pre-pandemic unemployment rate had a five in front of it.

    The twists and turns of the inflation story to date require treating the SMP forecasts with caution. Not least because there remain significant risks to a soft landing, including a still unpredictable international environment, the threat of persistently strong services inflation (currently running at its fastest rate since 2001) and the uncertain resilience of indebted households to past rate increases. It is certainly premature to declare any kind of victory. Keeping those caveats in mind, however, it’s still possible that there could be a happy ending to the post-pandemic inflation story after all.

    This article first appeared under the headline 'Once Upon A Time’ in the September 2023 issue of Company Director magazine.

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