Reserve Bank of Australia forecasts inflation will not return to target until December quarter 2025

Household consumption and incomes are set to take a battering well into next year as the economy slows under the weight of interest rate hikes and persistent inflation.

Economists say the Reserve Bank of Australia’s latest forecasts — which assume a cash rate peak of about 4.5 per cent — suggest it is more likely that the central bank will hike rates again in February if inflation proves tougher to push down than expected.

The RBA’s quarterly statement on monetary policy, released on Friday, reveals the central bank’s board considered keeping rates on hold at 4.1 per cent earlier this week, but chose to hike to 4.35 per cent because of concerns inflation was proving more stubborn.

The forecasts suggest real household incomes will continue to go backwards well into next year due to inflation remaining above the bank’s 2 to 3 per cent target until the December quarter of 2025.

Inflation is forecast to slide from 5.4 per cent in the September quarter to 4.5 per cent in the December quarter and persist between 3 and 4 per cent for much of the 18 months following.

At the same time, real household disposable income is set to only start to tick into positive territory in the second half of 2024, with income growth of 2.5 per cent expected in the year to December, rising to 3.9 per cent in the year to June 2025.

“Relatively weak” economic growth in the next year to 18 months is expected to be fuelled by strong population growth, supply constraints easing and the large public and private pipeline of infrastructure projects, as well as business investment and public demand.

But the bank acknowledges key uncertainties around its forecasts are inflation persisting at a higher rate for longer than expected, and weaker than anticipated growth.

“Domestic inflationary pressures are dissipating more slowly than previously thought,” the statement reads.

“Demand ... (is) stronger than anticipated as cost pressures have remained elevated.”

The statement outlines the possibility for more rate hikes, as most market economists and financial markets expect, and warns of possible shocks to inflation from global energy market disruptions and higher food prices due to El Nino.

As a share of household disposable income, scheduled mortgage payments have risen about 2.5 percentage points since the first quarter of 2022, the statement outlines — and that will increase as more borrowers’ fixed-term loans expire. It is expected to increase to about 10.5 per cent by the end of next year.

Westpac chief economist Luci Ellis noted the forecast for household disposable income was so weak that they were contingent on a near-zero household savings ratio in the first half of next year.

“It is hard to conceive how such an extended period of declining real incomes — even worse in per household terms — can coexist with a still-tight labour market,” she said, referring to the RBA’s expectations that the quarterly unemployment rate would only rise to 4.2 per cent by the end of next year, up from 3.6 per cent now.

Commonwealth Bank head of Australian economics Gareth Aird expects the unemployment rate to rise more quickly than the RBA, as well as other key indicators as households struggle with the repressive conditions.

He pointed out this week’s rate hike is unlikely to hit mortgages until February, while much of the tightening to budgets had also yet to arrive as some fixed-rate loans at ultra-low levels had not expired.

The bank has also reiterated the need to keep inflation expectations in check, because an increase would add to inflation pressure — particularly if productivity growth remained stagnant. To reverse it would require below-trend economic growth and lower employment.

“It is important to avoid this given the significant costs involved, namely even higher interest rates and a larger rise in unemployment,” the statement reads.

Though real incomes are going backwards due to high inflation, nominal incomes are increasing, with the RBA pointing out employee compensation had increased 10 per cent over the year to the June quarter — nearly the strongest growth since 1990.

It attributes some of the rapid rise in unit labour costs — how wages are calculated for inflation — to weak productivity outcomes, given growth has stagnated and labour productivity fell sharply in 2022-23.

The RBA is concerned about persistently high services inflation, which it says reflects elevated domestic cost pressures and “still robust” demand. While goods inflation has fallen substantially, it is still above average levels, particularly for consumer goods, groceries and new houses which are all still above pre-pandemic levels.

“Many firms expect to increase their prices by less over the next 12 months compared with the past 12 months, but the share expecting above-average increases is still much higher than prior to the pandemic,” the bank said.

The statement points out that 60 per cent of items measured to calculate the inflation figure still had price movements of above 3 per cent. While that’s down from 80 per cent last year, it is still in the top end seen in the three pre-pandemic decades.

Businesses in the bank’s liaison program have reported higher energy bills when contracts have been renewed, and a jump in retail rents, adding to cost pressures, alongside insurance, legal, accounting and administrative service price jumps.

Infrastructure and large construction firms reported strong demand and substantial work ahead, particularly related to renewable energy.

“Firms have noted that demand is exceeding available capacity across the non-residential construction sector; this is keeping materials and contractor costs elevated, which is flowing through to firms’ pricing,” the RBA said.

While labour availability has improved, it is still difficult compared to the pre-pandemic period, firms reported, and are looking for operational efficiencies to fund wage increases.