Are rate cuts off the table?

Undoubtedly the biggest economic story of the year has been the resilience of the labour market in the face of the RBA’s onslaught, along with the predictions (and misses) of imminent rate relief.

Having spent 12 months digesting 425 basis points of rate hikes, the economy delivered a defiant message in the final labour force report of the year:

• 3.9% unemployment rate
• 36,000 more people employed
• 27,000 fewer people unemployed
• Participation rate stable at recent highs

A cracking report on every measure, and the complete opposite of how the year was supposed to end.

To be clear – the macroeconomic strategy of 2024 was to weaken the labour market. Higher interest rates were supposed to dampen demand enough to increase the unemployment rate to around 4.5%.

Now you might wonder why the authorities would be trying to increase unemployment.

Their concern in a nutshell is that the economy is creating too many jobs for the available workforce. In this 'beyond-full-employment’ environment, says the textbook, workers will demand higher wages but firms can’t increase output. This will tend to drive prices upward in a so-called ‘wage-price spiral.’

Central banks have essentially one job which is to prevent this type of inflation because it can be catastrophic for the economy. And their only tool is the interest rate. To a hammer, everything looks like a nail.

Up until now, the general consensus has been that ‘full employment’ equates to an unemployment rate of around 4.5%. It is assumed that anything below that rate is inviting trouble.

That assumption is now looking questionable.

For one thing, inflation is coming under control in spite of the very low unemployment rate. While there are those who warn against complacency and point to “base effects” and “underlying” inflation, the reality is every measure is falling:

That the economy has been able to absorb so many rate hikes in such a short space of time without spiking unemployment has been a real head-scratcher.

Wage growth is arguably the most important data point in this whole conundrum. If the economy is operating beyond full employment, we would expect to see upward pressure on wages. Yet that seems to have stabilised at quite healthy levels:

So as we move into 2025, it might be time to consider the possibility that ‘full employment is more like 4.0%. It’s possible that the labour market has already found its new normal.

What does all this mean for interest rates?

If inflation stabilises and the labour market remains robust, there is no compelling reason for the RBA to cut rates.

That said, there are plenty of alternate futures.

It’s quite possible that the post-pandemic adjustment is still working itself out, and we haven’t yet reached a new equilibrium. Unemployment could still push higher next year if the rate hikes are still working their way through the system.

Another consideration is that, while Australia may be an island, our economy does not run in isolation. If other central banks are cutting rates—especially the Yanks—the RBA may be forced to cut if only to keep the currency competitive.

On the flipside, global political risks (such as a trade war) could push up the price of imports, driving inflation higher. This could cause the RBA to have to start hiking again if things get out of hand.

As always, the correct approach is to follow the data. In my opinion, the RBA has done a solid job of that this year but 2025 will be the real test.