As Australia eagerly awaits a possible interest rate cut, the big question is just how much financial pressure households can bear. 

    Since Australia’s central bank began lifting the target cash rate in May 2022, the domestic economic outlook has been dominated by the Reserve Bank of Australia’s policy tightening. So, if 2022 was mostly about when and how fast the RBA would tighten, and how high inflation would go, and if 2023 was mostly about where and when the peak in the cash rate would occur, and how quickly inflation would start to slow, what will be the corresponding questions for 2024? Subject to the inevitable, but still important, caveat about the risk of future shocks and surprises, it seems likely this year will be about whether and when an increasingly squeezed household sector will crack, and when the RBA will deliver its first rate cut.

    Looking back over the current monetary policy cycle, in 2022, the focus was on whether Martin Place had fallen too far behind the curve in allowing inflation to surge above target — and on the consequent struggle was to reconcile past forward guidance on interest rates with the increasingly urgent need to tighten policy much more aggressively than had originally been signalled. As the headline rate of inflation accelerated from an already above-target 5.1 per cent in the first quarter of 2022 to reach a peak of 7.8 per cent in the final quarter, the RBA busied itself delivering a brutal 300bp of rate hikes across the eight monetary policy meetings held between May and December 2022. That marks the highest total of annual net rate increases seen this century.

    Belts were tightened

    While the RBA remained firmly in tightening mode into 2023, by the second half of last year, the urgency had eased. Over the course of the year’s 11 RBA board meetings, the central bank announced a further 125bp of increases. That still delivered the (joint) second highest annual total of net rate increases this century. But while H1:2023 delivered 100bp of tightening and saw the RBA board increase rates in four of its five meetings, H2:2023 was different. Over the six meetings held between July and December 2023, the RBA delivered just one 25bp increase. Meanwhile, as the rate of increase in the cash rate target slowed, the headline rate of inflation also eased, falling from seven per cent in the March quarter 2023 to 5.4 per cent by the September quarter 2023.

    Over the course of 13 rate increases and 425bp of tightening, the RBA has managed shifts, shocks, and risks. The international environment has seen the reconstruction of pandemic-disrupted global supply chains, major food and energy price shocks triggered by the Russian invasion of Ukraine, and the consequences of new geoeconomic arrangements in global energy markets.

    Closer to home, Martin Place has been preoccupied by the strength of the Australian labour market, the implications for unit labour costs and the consequences for persistent price pressures in the labour-intensive services sector. It has also kept a watchful eye on inflation expectations, mindful that higher-for-longer inflation could influence Australians’ “inflationary psychology” and threaten the RBA’s inflation- fighting credibility, with this logic driving the November 2023 rate hike. And the RBA has warned repeatedly of significant uncertainties around the outlook for household spending.

    Households under the pump

    As 2023 ended, this final risk was rising in prominence in the face of evidence of an intensifying squeeze on household incomes. Forward-looking indicators of consumer sentiment had been mired at recession-like levels for much of the past year. Real household disposable income had been falling since the middle of 2022. And while total consumption spending had been sustained by rapid rates of net overseas migration, consumption per head was falling.

    The release of weaker than expected September quarter 2023 GDP data last December reinforced this message. Against the backdrop of a “per capita” recession, household consumer spending in real terms was flat over the quarter and down by 0.7 per cent in per head terms. The annual growth for household consumption was a meagre 0.4 per cent in the weakest result since the pandemic-hit first quarter of 2021. Real per capita consumption fell two per cent relative to Q3:2022. Granted, some of this weakness reflected the substitution of government consumption for private spending in the form of public subsidies for energy bills and childcare. But it also reflected a three-way squeeze on real incomes from higher interest rates, higher income tax payable and other increases in living costs.

    In nominal terms, last year, household gross income was squeezed by the strongest annual growth in income payable since 1977. Before the pandemic, in the final quarter of 2019, interest payments on dwellings had amounted to about 3.3 per cent of total gross household income, while income tax payments accounted for another 14.5 per cent. By the September quarter 2023, the debt service interest burden had climbed to 5.6 per cent and income tax payable to 17.2 per cent of gross income. To maintain consumption, households have had to trim their savings. The household saving ratio fell to just 1.1 per cent in the September quarter last year, well down from 7.1 per cent in the December quarter 2019 and some distance below the 2000–19 average of a little above four per cent.

    To date, households have been able to sustain their spending thanks to rapid growth in labour incomes from a still tight labour market, as well as by drawing down some of the “excess” savings accumulated during the pandemic. Rising house prices may also be delivering a wealth effect. But the labour market is set to weaken over the year ahead, growth in house prices is likely to slow, and the distribution of pandemic-era savings is highly uneven across households, leaving a significant share without much of a buffer.

    In this context, the destiny of the cash rate over 2024 could be driven by a race between the pace of disinflation on one hand and the squeeze on household consumption on the other. As the latter intensifies over the course of this year, the case for a first RBA rate cut will start to build.

    AICD chief economist Mark Thirlwell GAICD has focused on the international political economy at the Bank of England, JPMorgan, Austrade and Export Finance Australia.

    This article first appeared under the headline 'The Big Squeeze’ in the February 2024 issue of Company Director magazine.

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