Statement on Monetary Policy – May 20243. Outlook

3.1 The global outlook

Growth in Australia’s major trading partners is expected to be moderate and most central banks expect inflation to be close to target by the end of 2025.

Year-average GDP growth for Australia’s major trading partners is expected to ease to around 3 per cent in 2024 and to be a little higher in 2025. The overall outlook for growth in Australia’s major trading partners in 2024 is little changed (Graph 3.1). The stronger forecast growth in 2024 in the United States and China, which is also partly reflected in the recent pick up in global commodity prices, is offset by downward revisions to growth in New Zealand, Japan and some middle-income economies in east Asia. The unchanged outlook for Australia’s major trading partner growth in 2024 contrasts with an upgrade to the IMF’s forecasts for global growth, in part reflecting the fact that the US economy makes a larger contribution to global GDP than it does to Australia’s trade. The outlook for major trading partner growth in 2025 has been revised up a little, led by an upward revision to the outlook for China.

Most advanced economy central banks are expecting headline inflation to be close to 2 per cent by the end of next year, alongside widening output gaps and further gradual easing in labour market tightness. However, recent inflation and labour market data in the United States have been stronger than expected, prompting private forecasters to revise up their near-term projections for US inflation and market participants to scale back their expectations for the timing and extent of monetary policy easing by the Federal Reserve (see Chapter 1: Financial Conditions). In a number of other advanced economies, expectations for monetary policy easing have been scaled back a little against the backdrop of stronger near-term global inflationary pressures.

The outlook for growth in China has improved, although growth is still expected to slow over the next two years. The upgrade to the forecast reflects a stronger-than-expected outcome in the March quarter and confirmation that the authorities will target ‘around’ 5 per cent growth this year. Policy measures are expected to continue to support infrastructure and manufacturing investment, more than offsetting ongoing weakness in the property sector.

3.2 The domestic outlook

Economic growth is expected to remain subdued over most of 2024, with the outlook a little weaker than three months ago, as earlier interest rate increases continue to weigh on demand.

Overall, the forecasts for economic activity have been revised down slightly compared with three months ago. Household spending has been weaker and the saving rate stronger than previously anticipated. This is expected to continue in the near term, notwithstanding a stronger profile for employment and household income. In addition, the cash rate is assumed to remain around its current level until mid-2025, around nine months longer than assumed in February; this will moderate the expected pick-up in GDP growth. The technical assumption for the cash rate is based on pricing from overnight indexed swap markets on 1 May (see Table 3.1: Detailed Forecast Table for more information).

The near-term downgrade to GDP reflects a softer near-term outlook for household consumption and dwelling investment. The soft outlook for GDP growth in the first half of 2024 reflects subdued growth in domestic final demand, with weakness most pronounced in the household sector (Graph 3.2). While income growth in late 2023 has been stronger than expected, consumption growth has remained a little weaker than anticipated, resulting in a much higher household saving ratio. Overall, households have been saving more than expected three months ago in response to higher interest rates and the economic environment. A key judgement in the forecasts is that consumption growth remains subdued for most of 2024, despite real income growth picking up in response to strong labour income growth, a smaller drag from (declining) inflation, and the Stage 3 tax cuts (Graph 3.3). Continuing capacity constraints and weak demand will hamper dwelling investment in the near term, with affordability constraints and high construction costs expected to continue weighing on new demand and activity in 2025 and 2026.

The levels of public spending, business investment and services exports are expected to remain high relative to recent years, but growth is forecast to slow in 2024 from the high rates seen in 2023. Business investment growth is expected to ease in response to subdued domestic demand and cost pressures and despite support from investment related to the large pipeline of infrastructure work, digitisation and the renewable energy transition. Growth in spending by tourists and international students (which is counted as exports) is also expected to slow as the recovery following the reopening of the border nears completion.

GDP growth is forecast to increase gradually from late 2024, driven by a pick-up in household consumption growth. Consumption growth is expected to pick up to around pre-pandemic averages in 2025 following the earlier recovery in real incomes. This implies that the household saving ratio will lift over 2024 before declining later in the forecast period, though there is considerable uncertainty around this expectation (see section 3.3 Key judgments, below) (Graph 3.4). Dwelling investment growth is expected to pick up from around mid-2025. This reflects increasing demand for new housing as recent population growth, higher prices for established housing and improved conditions in the construction industry offset the effects of affordability constraints and high construction costs. The higher assumed cash rate path will moderate the pick-up in GDP growth. Overall, the forecasts for GDP growth beyond the near term are broadly unchanged from three months ago. However, the level of GDP at the end of the forecast horizon is a little lower.

The labour market is expected to ease further to be broadly consistent with full employment in the next couple of years.

Labour underutilisation rates are forecast to rise further, but this is starting from a lower (tighter) level and is at a slightly more gradual pace than anticipated three months ago. Much of the labour market adjustment to subdued economic growth has occurred through a decline in average hours worked and vacancies. Both the unemployment rate and the broader hours-based underutilisation rate (i.e. people working fewer hours than desired) have increased only gradually from their late-2022 troughs, though the increase in the latter has been a little more pronounced. It is judged that there will continue to be an adjustment to softer labour demand through a further decline in vacancies and average hours worked, as observed during previous labour market downturns. The unemployment rate is also expected to increase gradually over coming quarters before stabilising around levels consistent with full employment from mid-2025 onwards (Graph 3.5).

Employment growth is expected to slow but remain positive as demand for labour eases. Growth in employment is forecast to be below growth in the working-age population for a time, resulting in the forecast gradual increase in the unemployment rate. The labour force participation rate is expected to decline slightly alongside the cyclical slowing in the economy. The participation rate has been supported by longer run trends of increased participation by females and older workers and is expected to remain high by historical standards over the forecast horizon.

Growth in nominal wages is expected to moderate as the labour market eases.

Nominal wages growth looks to be around its peak and is expected to decline gradually. Wages growth has started to slow in parts of the private sector and this is expected to become more broadly based and pronounced over the forecast horizon. Growth in nominal wages is forecast to ease a little more gradually than previously expected, reflecting both the strength in recent wage outcomes and the slightly stronger outlook for the labour market (Graph 3.6).

Real wages are forecast to increase over the forecast horizon as nominal wages growth is expected to decline more slowly than inflation (Graph 3.7).

Growth in unit labour costs remains strong but is expected to moderate further over the coming years. Nominal unit labour costs – the measure of labour costs most relevant for firms’ cost of production and so for inflation outcomes – are forecast to grow at a less rapid pace as nominal wages growth gradually eases and labour productivity growth picks up. Growth in nominal unit labour costs is expected to slow to a rate consistent with inflation returning to target, assuming labour productivity growth converges to around its long-run average and wages growth eases in line with forecasts. If productivity is weaker than assumed, businesses would face higher costs of producing a given amount of output to the extent they have limited ability to adjust wages to reflect lower productivity outcomes.

Productivity is assumed to continue to increase, although substantial uncertainty remains around the outlook. Labour productivity increased by less than anticipated in the December quarter, and assumed productivity growth in the first half of 2024 has also been revised a little lower. The outlook further out is little changed. Growth is assumed to stabilise around its long-run (excluding the pandemic) average rate over the forecast period. The pick-up in labour productivity growth reflects the recovery in the capital-to-labour ratio, consistent with the recent strength in business investment, and a pick-up in multifactor productivity growth (i.e. output growth not attributed to labour or capital growth) as capacity constraints ease in some industries such as construction (Graph 3.8).

However, the outlook for productivity – which is a key determinant of the economy’s supply capacity, real incomes and hence living standards – is highly uncertain. Productivity growth weakened over the 2010s, reflecting various factors such as declining rates of new business formation, slowing capital and labour reallocation, slowing knowledge diffusion and declining competition. If we return to these slower rates of dynamism, productivity growth will be weaker than long-run pre-pandemic trends. Furthermore, the extent and timing of any potential gains from the adoption of new technologies, including of artificial intelligence, are highly uncertain. Major gains from general purpose technologies often take many years to manifest as businesses adapt their business models to harness the benefits.

Subdued growth in aggregate demand is expected to return the economy into balance in the next couple of years.

The staff forecast is for the output gap to close over the next couple of years, but at a more gradual pace than over the past year, returning the economy to a more balanced state. Recent data suggest that the output gap (the difference between actual and potential output) remained positive late last year (see Chapter 4: In Depth – Potential Output for an explanation of these concepts), indicating that demand continued to exceed sustainable supply capacity. However, there is considerable uncertainty over both the estimates of the output gap and the pace of decline in the output gap.

In addition to uncertainty about the outlook for aggregate demand, the pace at which the output gap closes is sensitive to the assumption about growth in the economy’s potential output. After a period of subdued growth in potential output over recent years – largely due to weak trend productivity growth – potential output is assumed to grow at around 2½ per cent per year over the next few years, which is not too far from the longer run average growth rate. This reflects a decline in population growth from its current high rate being offset by an increase in trend productivity growth towards its pre-pandemic rate. However, there is considerable uncertainty around these assumptions.

Headline inflation will rise in the near term, while trimmed mean inflation is expected to ease further to fall below 3 per cent in 2025 and to the midpoint of the target in 2026.

Headline inflation is expected to lift in the near term from temporary factors, and then decline a bit more gradually than previously forecast. The recent rise in petrol prices and unwinding of electricity rebates are each expected to add ¼ percentage points to year-ended headline inflation in the December quarter of 2024 (Graph 3.9). For underlying inflation, the near-term forecast has been revised higher owing to the stronger-than-expected March quarter inflation data, which suggest the pace of disinflation has slowed, and the economy is assessed to have slightly less spare capacity than previously estimated (Graph 3.10).

Inflation is forecast to be within the target range in 2025 and to reach the midpoint of the target in 2026. Despite the upward revision to inflation over the year ahead, the inflation outlook is little changed further out. The output and unemployment gaps are projected to close over the forecast period, bringing the economy back to a balanced position and inflation back to target. Inflation expectations are assumed to remain consistent with achieving the inflation target within this timeframe.

Services inflation remains elevated and is expected to decline only gradually. Strong domestic cost pressures (both for labour and non-labour inputs) have held up inflation outcomes in recent quarters, and services inflation was a little stronger than expected in the March quarter. Services inflation is expected to ease gradually as growth in input costs and demand moderates over the forecast horizon. The more gradual decline in services inflation relative to goods inflation is in line with trends overseas; the experience abroad also highlights the risk that services inflation could be more persistent than expected (see section 3.3 Key judgements, below). Further easing in services inflation is necessary for inflation to return to target.

Rent inflation is expected to remain high over the entire forecast period. Advertised rents growth remains elevated due to ongoing tight rental market conditions across capital cities. Demand for housing has outstripped supply in recent years such that vacancy rates remain below average; in part, this reflects solid growth in nominal incomes, strong population growth and an increased preference for a smaller average household size since the pandemic. It will take some time for the expected increase in dwelling investment over the next few years to feed through to lower pressure on rent growth and this will also depend on developments in housing demand, including preferences for household size.

Goods inflation is expected to be relatively modest over the forecast horizon. The easing in imported goods inflation as global supply chains normalised last year has largely passed through to domestic goods prices. The risk of a large spike in global shipping costs has receded somewhat and growth in domestic labour and non-labour costs is moderating (though both remain high).

3.3 Key judgements

The central forecasts incorporate many judgements, such as the choice of models used and whether to deviate from the models given the signal from recent data or qualitative information from liaison. The key judgements that the staff have extensively considered and incorporated this forecast round are included below.

Consumption is expected to remain subdued for most of 2024.

The consumption forecasts are guided by a range of models that suggest that consumption growth will pick up quickly over coming quarters, reflecting the earlier rebound in housing prices and the strong recovery in real household incomes expected from mid-2024. However, the staff have applied downwards judgment to the model forecasts in the near term. In making this judgment, the staff have taken considerable signal from recent outcomes, where consumption growth has been weaker than expected and the saving ratio has been higher than expected, as well as the experience of many peer economies, where consumption growth is yet to increase despite an earlier recovery in income growth.

There is less spare capacity in the labour market than earlier anticipated.

The unemployment rate has increased since its lows in late 2022 but appears to have stabilised more recently. The staff forecast is for the unemployment rate to increase a little more gradually than previously expected over the next year, with this view guided by recent stronger-than-expected labour market outcomes and a suite of models. This would suggest that there is more tightness in the labour market than previously assumed, which, taken by itself, implies more upward pressure on inflation. Overall, the unemployment rate forecast is consistent with the historical relationship between the unemployment rate and the trajectory for GDP growth. The forecasts suggest that a little under half of the adjustment will be via relatively slow growth in employment, consistent with the experience in mild downturns. If the hours adjustment has now run its course, then there may be a more rapid increase in the unemployment rate.

Despite the upward surprise in the March quarter inflation data, disinflation is expected to continue.

The central forecast is for inflation to continue to decline over the forecast horizon, albeit at a slower pace than it has over the past year and from a higher starting point. This forecast disinflation is guided by a suite of models that take some signal from the stronger-than-expected March quarter CPI outcome. However, it is possible that more signal should be taken from the upside data surprise as it may suggest that there is more persistence or ‘stickiness’ in domestically determined components of the basket than currently assumed (which is not offset by the higher cash rate path assumption underpinning these forecasts). This is also consistent with there being less spare capacity in the economy and the resilience in the labour market of late. Recent inflation outcomes in some overseas economies, such as the United States, provide additional evidence of the risk that high inflation may be more persistent than currently anticipated. One way through which the forecasts for services inflation already incorporate some upward judgment is through expected labour cost growth, where the staff’s forecast for wages growth is higher than suggested by the suite of wages models.

3.4 Key risks to the outlook

The recent flow of data suggests that the risk that inflation takes longer to return to target than anticipated has increased since the February Statement. At the same time, the risk that demand is weaker than expected (leading to spare capacity) is still material, with recent labour market and consumption data providing different signals about the strength of domestic demand. With inflation continuing to be above target, the costs associated with the upside risks are larger. It would be costly (in terms of both the employment and inflation objectives) if a sustained period of high inflation led to inflation expectations drifting upwards. On the other hand, while some of the downside risks to the outlook would see a faster return to the inflation target, this would likely be accompanied by a cost to the employment objective.

Key risk #1 – If inflation takes longer to return to target than anticipated, the greater the risk that inflation expectations drift higher, which would require a costly period of higher unemployment.

Inflation is expected to be above the target range for around four years in total according to staff forecasts. The central forecast is for inflation to decline alongside an easing in the labour market. This assumes inflation expectations remain anchored over the period ahead. A sustained period of inflation being above the target range could result in inflation expectations drifting higher. A drift higher in inflation expectations would lock in a rate of inflation and nominal wages growth that is persistently higher, with no benefit to real wages. History suggests that it would require more monetary policy tightening and a sustained and costly period of higher unemployment to reset inflation expectations and bring inflation back to target.

Some key channels through which inflation could be higher for longer than forecast include:

• There may be less spare capacity in the economy than we currently judge. There is a risk that the forecast easing in the labour market is not sufficient to return inflation to target if we have misjudged the degree of spare capacity. Uncertainty about the extent of spare capacity is more elevated than normal (see Chapter 4: In Depth – Potential Output), and there is a risk that the degree of excess demand in the economy is larger than currently assumed. If this risk scenario played out, wages growth and domestic inflation would be persistently higher than forecast.
• Demand could be stronger than expected, and inflation could be higher for longer than anticipated as a result. The recovery in consumption over the coming 12 months is expected to be gradual, with households choosing to save a large share of the expected increase in incomes in the second half of 2024. However, households might instead choose to spend more of this income boost, especially in light of their already-large holdings of liquid assets. There is also a large amount of work in the construction pipeline that could be worked through more quickly than anticipated, increasing the competition for scarce labour and materials. These scenarios would result in employment growth being stronger than forecast in the near term and inflation declining by less than anticipated.
• Services inflation could be more persistent than anticipated. The evidence from other economies suggests that services inflation has moderated only gradually (and, in some cases, recent progress appears to have stalled), despite significant goods disinflation.
• Supply shocks could boost inflation. While the pandemic-related disruptions to supply chains have largely resolved, the risk of other supply shocks have increased. If there were to be trade disruptions from an escalation of geopolitical tensions, global commodity prices could increase and disrupt the supply of goods. This could lead to price inflation being higher than forecast for a time, which could further delay the return of inflation to target.
• Inflation could be more persistent than expected if productivity growth does not pick up. The baseline forecasts include an assumption that labour productivity growth increases to the rate recorded in the decades preceding the pandemic. Productivity growth could prove weaker than assumed if capital deepening does not eventuate (i.e. the rate of investment is insufficient relative to employment growth) or if the structural factors that were key drivers of the productivity growth slowdown since the mid-2000s persist (e.g. declining business dynamism and slowing technology adoption). If productivity is weaker than assumed, businesses would face higher costs of producing a given amount of output, putting upward pressure on prices paid by consumers.

Key risk #2 – If demand is weaker than expected (or supply is larger than expected), it could lead to spare capacity in the labour market.

With the labour market expected to ease to be around the level consistent with full employment during the forecast period, materially weaker demand for goods and services would lead to spare capacity in the labour market. At the same time, weaker demand would also temper inflationary pressures, resulting in inflation returning to target earlier.

Some key channels through which demand could be weaker than expected include:

• The recent weakness in household consumption could persist for longer than expected. This could occur if the decline in real disposable incomes over the past couple of years has a larger or more persistent effect on consumption than anticipated; consumption growth has not picked up in response to a recovery in real incomes in a number of peer economies.
• International demand for Australian goods and services could be weaker than expected. Although the recent flow of data suggests the downside risks to global growth have diminished, there are still some risks that would have a significant adverse effect on growth were they to materialise. There are ongoing downside risks to Chinese economic growth, which could eventuate if the weak conditions in the property sector have larger-than-expected spillovers to the household sector or constrain investment through their effect on local government finances. Further, trade tensions remain elevated and a further increase in tensions or restrictions on trade would lead to lower global growth.

3.5 Detailed forecast information

The RBA forecasts reflect our best estimate of future economic outcomes and are published every quarter. The forecasts are pulled together using a combination of single-equation models, leading indicators (for nowcasts and the near term) as well as applying appropriate judgement to incorporate information that cannot easily be captured by models (e.g. information from the liaison program or large shocks such as the pandemic). These forecasts are interrogated thoroughly during the forecast process to ensure they are internally consistent and produce a clear economic narrative. The full-system economic model (known as MARTIN) is run in parallel and used as a consistency check on the forecasts.

The forecasts incorporate several technical assumptions:

• The cash rate is assumed to move broadly in line with expectations derived from financial market pricing; previously this assumption also included information derived from surveys of professional economists, but recent staff analysis has found that using only financial market pricing is the best predictor of the future cash rate path unless there is unusual financial market volatility. Using this methodology, the cash rate remains around its current level until mid-2025 before declining to around 3.8 per cent by the middle of 2026. This cash rate path is higher than at the time of the February Statement.
• The exchange rate is assumed to be unchanged at its current level, which is 1 per cent higher than the February forecasts on a trade-weighted basis.
• Crude oil prices are assumed to be broadly unchanged around their current levels for the rest of the forecast period, which is around 4.6 per cent higher than at the time of the February Statement.
• The assumed level of the population is broadly unchanged relative to the February Statement. Year-ended population growth is assumed to have peaked in the September quarter of 2023 at 2.5 per cent, after which it is expected to decline back to its pre-pandemic average of around 1.4 per cent.

Table 3.1 provides additional detail on forecasts of key macroeconomic variables. The forecast table from current and previous Statements can be viewed, and data from these tables downloaded, via the Statement on Monetary Policy – Forecast Archive.

Download a PDF version of this table