Statement on Monetary Policy – February 20252. Economic Conditions

2.1 Global economic conditions

Elevated geopolitical risks and global policy uncertainty are creating a challenging economic environment.

Global trade policy uncertainty has increased and is adding to broader policy uncertainty (Graph 2.1). The tariff policies of the new US administration are evolving rapidly, with a wide range of outcomes possible. Other economies’ responses to potential tariffs also add to the uncertainty. In addition, changes to fiscal and immigration policies and deregulation are under active consideration by the US administration and have the potential to materially affect the US growth and inflation outlook if implemented, with likely spillovers to the global economy including Australia (see Chapter 3: Outlook). Uncertainty about the outlook for policy is also elevated in major economies outside the United States, with elections underway or anticipated in Europe, Asia and Canada, and uncertainty about the fiscal policy outlook in China. While financial markets are currently pricing in benign policy impacts, particularly in the United States (see Box A: Implications of US Policy Settings for Financial Markets), uncertainty is creating a challenging environment for businesses and households.

These developments are taking place against a backdrop in which US growth has been surprisingly robust, whereas the recovery in several other advanced economies has been more gradual than expected.

US GDP growth remained robust and surprised to the upside relative to Consensus forecasts at the time of the November Statement. Quarterly growth slowed slightly in the December quarter, but by less than previously expected; consumption and real income growth remained solid. Timely indicators such as surveyed business conditions are still pointing to overall strong growth (Graph 2.2). Business investment intentions have also continued to improve in recent months, consistent with expectations for changes to US tax policies and deregulation. US labour market conditions appear to have stabilised at a level consistent with the Federal Reserve’s assessment of full employment, and earlier downside risks of a deterioration in the labour market have diminished substantially. Stronger-than-expected employment growth over recent months has supported a slight decrease in the unemployment rate despite an uptick in labour force participation.

Growth in other advanced economies remains sluggish. GDP growth in the euro area and Sweden slowed slightly in the December quarter and was weaker than expected at the time of the November Statement. Partial data point to weaker growth in the United Kingdom as well. Consistent with ongoing weakness in GDP growth, labour markets have continued to ease in most peer economies as growth in demand for labour remains low. Business conditions also remain subdued, and, despite solid income growth, consumption growth remains subdued in most of these economies. By contrast, earlier cuts to policy rates in Canada and Sweden appear to be starting to support a pick-up in employment and consumption growth in these economies.

Disinflation has progressed mostly in line with, or faster than, expectations, but prospective US tariffs pose new upside risks to US inflation in particular.

Underlying inflation has continued to ease in most advanced economies, and in some cases has declined more quickly than expected (Graph 2.3). Non-housing services inflation – which is most closely tied to domestic economic conditions – has continued to ease, and on a quarterly basis is now close to historical averages in several economies. Housing services disinflation has been slower, although rental inflation appears to have passed its peak in most countries and leading indicators point to further easing. Goods inflation has continued to increase gradually and is generally at around its historical average. The prospect of additional US tariffs presents an upside risk to goods inflation there and – together with recent strong growth and inflation data and prospects of more stimulatory fiscal policy – has raised the US inflation outlook. The stronger US inflation outlook has seen both market-based measures of inflation expectations and policy rate expectations revised up in the United States (see Chapter 1: Financial Conditions). Elsewhere, inflation risks are more balanced. Some central banks (such as the Riksbank, Bank of Canada and European Central Bank) view inflation as having returned sustainably to target, or being close to doing so, and consistently undershooting the inflation target remains a risk in those economies if growth does not pick up.

Economic activity in China strengthened towards the end of 2024.

China achieved its 5 per cent year-average growth target in 2024, following strong growth in the December quarter and upward revisions to growth in previous quarters. Net exports made a significant contribution to growth in the December quarter, in part reflecting a large pick-up in merchandise exports to the United States in December as US importers brought forward shipments ahead of expected tariff increases. Growth in consumption also strengthened, supported by government subsidies to trade in durable goods including cars and appliances (Graph 2.4). Authorities have announced further fiscal stimulus measures aimed at boosting consumption, such as an expansion in the range of consumer durable goods eligible for household subsidies and civil servant pay increases. Robust growth in the manufacturing and infrastructure sectors continued to offset the drag from declining real estate investment.

Conditions in the Chinese housing market have improved after recent policy support, but they remain weak and there are still headwinds to a sustained recovery. National new housing sales in December were 8 per cent above their recent trough, and their prices increased for the first time in over a year. However, the pick-up in new housing sales has been concentrated in a few larger cities, and Chinese developers remain under significant financial pressure, limiting their ability to begin new work. New housing starts are yet to pick up materially and land purchases by developers remain at very low levels.

Commodity market sentiment has been resilient despite concerns about the outlook for Chinese growth, including from higher US tariffs. Iron ore prices have increased, though they remain well below levels seen in recent years. Coking coal prices have declined, though this partly reflects strong production growth in China (Graph 2.5). The impact of tariffs on steel and aluminium imports announced by the US administration on iron ore and bauxite prices is uncertain but likely small, as is the impact on Australian exports of these commodities.

2.2 Domestic economic activity

Australian GDP growth picked up a little in the September quarter, but remained below estimates of potential growth.

GDP growth was 0.3 per cent in the September quarter, a touch below our expectations in the November Statement of 0.4 per cent (Graph 2.6). The ABS also downwardly revised growth slightly over the preceding three quarters, such that year-ended GDP growth was 0.2 percentage points lower than had been expected in November; the revisions suggest that momentum in domestic activity earlier in 2024 had been a little weaker than previously thought. Partial indicators suggest that quarterly GDP growth picked up further in the December quarter, led by an increase in household consumption. Recent flooding in North Queensland will weigh on economic activity in the affected regions in the March quarter but the effects are not expected to be large enough to impact aggregate GDP growth.

Public demand has grown strongly in recent quarters. Recent growth in public consumption largely reflects an increase in the provision of government services as well as subsidies to households. Public investment also grew strongly in the September quarter, more than reversing a decline earlier in the year, although much of this strength reflected import-intensive spending on defence projects. Private demand picked up a little in the September quarter, but growth remained subdued. Abstracting from the effect of electricity rebates, household consumption picked up modestly but by a little less than expected, alongside growth in real household disposable income following the Stage 3 tax cuts. New dwelling investment was relatively flat over the year and growth in business investment has moderated sharply from the rapid growth rates seen in recent years.

Export growth was weaker than expected over the year to the September quarter, largely driven by services exports. Education exports were weaker than expected due to a tightening in student visa requirements and an unexpected decline in the average expenditure of international students. The ABS upwardly revised the level of imports over recent years to reflect greater use of digital services, though offsetting upward revisions to household consumption left GDP little changed.

Underlying household consumption growth edged up in the September quarter and has shown signs of picking up further in December.

While household consumption was unchanged in the September quarter, underlying consumption growth – which strips out the effect of energy rebates from household spending – picked up. This increase in underlying consumption was consistent with the pick-up in real disposable income growth seen in this period, as the Stage 3 tax cuts reduced income tax payable. Analysis suggests that households typically spend around 20 to 30 cents of every extra dollar of income (such as due to a tax cut) over the following year or so. While consumption growth in the September quarter was broadly as expected, growth over the year was weaker than expected following historical data revisions (see Box B: Consumption and Income Since the Pandemic).

Timely indicators suggest that consumption growth increased a little further in the December quarter, although evolving seasonal spending patterns are making it difficult to gauge underlying momentum (Graph 2.7). It remains uncertain how much of the recent strength in the partial indicators reflects price-sensitive consumers concentrating spending around sales events in the December quarter or a genuine improvement in underlying momentum following the earlier stabilisation of real income growth and the boost to incomes from the Stage 3 tax cuts. Our current assessment is that the December quarter outcome reflects a bit of both; the pick-up in growth in categories not impacted by late-November Black Friday sales (such as eating out, transport, and recreation and culture) provides some evidence that underlying momentum has improved. Liaison contacts generally expect little change in conditions over coming months, with demand expected to be boosted by any interest rate cuts. Contacts continue to report that consumers remain price sensitive, and this is expected to persist for some time.

The level of business investment has stabilised, and firms expect it to remain relatively steady over 2025.

The level of business investment was broadly unchanged over the year to the September quarter, although there were notable differences across components. Non-mining construction and machinery and equipment investment has been steady in recent quarters. By contrast, non-mining software investment has continued to grow strongly, while mining investment has declined. As of the September quarter last year, firms were expecting investment over 2024/25 to remain around similar levels to last financial year, although their expectations could be affected by international developments. Further out, growth in investment is expected to be supported by the large pipeline of renewable energy investment as the Australian energy sector decarbonises, investment in data centres as Australian businesses continue to migrate services to the cloud and take up artificial intelligence, and investment in computer software and related products.

Growth in both housing prices and advertised rents has been subdued in recent months, following a slowing in underlying demand for housing.

A further increase in average household size and a slowing in population growth have contributed to subdued growth in advertised rents (Graph 2.8). Advertised rents inflation has eased noticeably since July 2024 in monthly terms and this has contributed to an easing in CPI rents inflation (see section 2.4 Inflation). In the December quarter, advertised rents were relatively flat in Sydney and Melbourne. Advertised rents continued to increase in Adelaide, Perth and Brisbane, but at a slower pace than earlier in the year.

Housing price growth was weak in the December quarter and has moderated by more than expected. This is consistent with weaker housing activity indicators in late 2024, such as the decline in auction clearance rates and expectations of future housing price growth. While the easing in established housing price growth has been relatively broadly based by capital city, there continues to be variation across states.

2.3 Labour market and wages

Labour market conditions are assessed as remaining tight and unit labour cost growth remains high.

The easing in the labour market stalled in the second half of 2024, with conditions assessed as remaining tight relative to full employment. Employment growth has been strong over recent quarters, largely reflecting rapid growth in non-market sector employment, particularly in the health care industry. It is likely that this has contributed to tight labour market conditions in other industries. Market sector employment was flat in the first half of 2024 but picked up in the September quarter (the latest data available). Consistent with strong employment growth and the easing in the labour market having stalled, private sector wages growth was steady in the September quarter. Recent rates of wages and productivity growth imply that labour cost growth has eased but remains above rates consistent with inflation being at target. These key trends in the labour market are explored further in this section.

The easing in the labour market that had been underway since late 2022 has stalled and some key indicators suggest that conditions tightened a little in late 2024.

The unemployment rate edged lower in the December quarter to 4 per cent, around its mid-2024 level (Graph 2.10). That was in contrast with our expectation in November for a slight increase following subdued economic growth. The underemployment rate has been trending lower and is now 0.7 percentage points below its level in May 2024. Other measures of labour underutilisation, including the hours-based underutilisation rate – a broader measure of spare capacity – and the medium-term unemployment rate also declined or were little changed in late 2024.

Employment growth remains strong and has continued to outpace population growth. The employment-to-population ratio rose noticeably over 2024 to reach a record high in December, consistent with labour demand remaining solid in aggregate. By contrast, employment-to-population ratios in peer economies generally declined over this period. The strength in Australian employment growth in late 2024 looks to have coincided with subdued economic growth, consistent with ongoing weakness in labour productivity.

The participation rate – the share of the working-age population either employed or searching for a job – has also reached historical highs, though it has increased by less than expected over recent months. The strength in the participation rate has likely reflected a combination of a still-tight labour market and ongoing cost-of-living pressures. The increase in the aggregate participation rate over 2024 was broadly based across most age and sex cohorts. Longer run trends of higher female and older worker participation have also likely supported recent participation rate outcomes.

Most near-term leading indicators do not point to much further easing in the labour market. The job vacancy rate remains elevated and increased a little in late 2024, pointing to a modest tightening in labour market conditions. Further, a survey of households suggests that expectations for the unemployment rate remain slightly below the long-run average. By contrast, measures of job ads have either steadied or declined slightly (Graph 2.11).

Much of the recent strength in employment growth has been driven by the non-market sector, but this has affected labour market conditions in the market sector.

The non-market sector accounts for around three-quarters of aggregate employment growth since mid-2023. Employment in the non-market sector, which is primarily made up of the health care and education industries, is typically less sensitive to the business cycle and has been growing strongly in recent years (Graph 2.12). By contrast, year-ended employment growth in the market sector, which is more cyclical, has been much softer, though still positive, over the past year. This is consistent with the observed easing over 2024 in measures of employment intentions from business surveys, which tend to better capture developments in the market sector. However, employment growth in the market sector picked up in mid-to-late 2024 alongside a tick-up in market sector vacancies.

Strong labour demand in the non-market sector has likely contributed to tighter conditions in the market sector. While growth in employment has been concentrated in the non-market sector, and in particular the health care industry, the market and non-market sectors draw from the same pool of labour. The strong growth in health care employment has affected broader labour market conditions, drawing in workers and contributing to tight conditions facing firms in other industries (see Box C: Health Care Employment and its Impact on Broader Labour Market Conditions). This emphasises the need to look at aggregate labour market conditions when assessing the outlook for wages and inflation.

Productivity growth remains weak, weighing on the growth of the economy’s supply capacity and incomes.

Total labour productivity decreased by 1.1 per cent over the year to the September quarter. Looking through pandemic-related volatility and taking account of recent data revisions, labour productivity is around its pre-pandemic level (Graph 2.13). The recovery in the capital-to-labour ratio has slowed over the past year, contributing to weak labour productivity growth. Over the past year, multifactor productivity – which captures how efficiently the economy is using all its inputs – has also been weak.

Wages growth in the September quarter of 2024 was 0.8 per cent, the same as in the March and June quarters and a little weaker than expected.

Private sector wages growth was steady at 0.8 per cent in the September quarter as expected but eased further in year-ended terms. The pace of quarterly private sector wages growth – as measured by the Wage Price Index (WPI) – was unchanged in the September quarter, following a period of moderation as labour market conditions were easing (Graph 2.14). Reports from liaison continue to suggest that some firms are offering larger wage increases than otherwise to attract and retain staff, consistent with tight labour market conditions. However, the rate at which workers have been moving between jobs – as reflected by the number of quits as a share of filled jobs – has continued to decline recently to be below its trend (Graph 2.15). This decline in job-switching has been driven by lower job mobility within the market sector and suggests that inter-firm competition to attract and retain staff has eased. As a result, there may be less upward pressure on wages in the near term than implied by other measures of labour market tightness, such as the unemployment rate (see Key risk #1 in Chapter 3: Outlook.)

Public sector wages growth has been volatile and was weaker than expected in the September quarter. Public sector wages, which are mostly set through enterprise bargaining agreements (EBAs), typically take longer to respond to changing economic conditions than private sector wages. Wage negotiations in the public sector have often referenced increases to the cost of living over the past three years. Public sector wages growth eased by more than expected in the September quarter, with recent volatility partly reflecting delays around the finalisation of some major agreements. These agreements are now expected to flow through in coming quarters, which would see public sector wages growth pick up in the near term and may also contribute to volatility in quarterly WPI outcomes (see Chapter 3: Outlook).

By method of setting pay, the easing in year-ended wages growth in the September quarter was more pronounced for those on award wages and EBAs. This was largely because the 3.75 per cent annual increase to modern award wages was lower than the 2023 increase of 5.75 per cent, and there were no additional one-off administered wage increases in the quarter. Workers paid under individual agreements, whose wages tend to be the most responsive to current labour market conditions, have experienced a more gradual easing in year-ended wages growth. Consistent with the stabilisation in labour market conditions recently, the quarterly pace of wages growth for individual agreements has also been steady recently.

Unit labour cost growth continued to ease in the September quarter but remains higher than is consistent with inflation being sustainably at the midpoint of the target range.

Year-ended unit labour cost growth eased to 4.6 per cent in the September quarter. Year-ended growth in nominal unit labour costs eased significantly in the quarter, although growth on a quarterly basis tends to be volatile (Graph 2.16). The lower outcome reflected lower growth in the compensation of employees per hour (despite increases to the superannuation guarantee), which outweighed upward pressure on labour costs from continued weakness in productivity growth.

2.4 Inflation

Underlying inflation eased by more than expected in the December quarter.

Trimmed mean inflation was 0.5 per cent in the December quarter and 3.2 per cent over the year. The two-quarter annualised rate was 2.7 per cent (Graph 2.17). The easing in the quarter was broadly based but also reflected some temporary factors. Several components experienced faster disinflation in the quarter than expected. New dwelling costs declined in the quarter, after growing at a quarterly pace of between 1 and 1½ per cent since the March quarter of 2023. Inflation for market services and private rents (excluding the effects of rent assistance) also eased by more than expected. The easing in trimmed mean inflation was also partly driven by government cost-of-living measures, as well as an adjustment made by the ABS to the child care inflation series to correct for past errors; we estimate that these temporary factors caused quarterly trimmed mean inflation to be around 0.1 percentage points lower than otherwise.

Headline inflation eased in year-ended terms, mostly reflecting the impact of government subsidies to households. Headline CPI inflation was 0.3 per cent in the December quarter (seasonally adjusted) and 2.4 per cent over the year, down from 2.8 per cent over the year to the September quarter (Graph 2.18). Changes to federal and state government subsidies, including electricity rebates, are estimated to have subtracted around 0.6 percentage points from year-ended headline inflation in the December quarter. Nonetheless, year-ended headline inflation is expected to increase in the September quarter of 2025 to be above the target band as some of these rebates unwind (as currently legislated).

Housing inflation eased in the December quarter, owing to a slowing in inflation for new dwelling costs and rents.

New dwelling cost inflation eased significantly to 2.9 per cent over the year to the December quarter, from a rate of around 5 per cent that had prevailed since the September quarter of 2023. Information from liaison suggests that weakness in demand to build new houses is contributing to builders offering discounts, particularly in Sydney and Melbourne. All else equal, this discounting may have contributed to lower new dwelling inflation than would have been expected based on the elevated, but declining, pipeline of work to be done. Information from liaison partially attributes the weak demand to consumers’ uncertainty around future interest rates. Improvements in labour availability in residential construction have been observed in eastern cities, while trade shortages persist in Perth, Adelaide and Brisbane. As a result, the disparity in new dwelling cost inflation across capital cities remains large (Graph 2.19).

CPI rent inflation slowed in the December quarter due to the effects of Commonwealth Rent Assistance (CRA) and the recent slowing in advertised rents growth. Rent inflation – for the stock of rental accommodation captured in the CPI, which excludes regional areas – was 0.6 per cent in the December quarter and 6.4 per cent over the year, down from 6.7 per cent. Rent inflation, excluding the effects of the CRA, has continued to moderate in recent quarters from an elevated level, reflecting the gradual pass-through of the slowing in advertised rents inflation (Graph 2.20). The recent easing in advertised rents inflation is consistent with softening demand for housing through an increase in average household size (possibly due to affordability constraints) and slowing population growth.

Services inflation moderated further in the December quarter.

Market services inflation (excluding domestic travel and telecommunications) eased by more than expected but remained elevated at 4.1 per cent over the year to the December quarter. This disinflation has been broadly based across different types of market services (Graph 2.21). However, input cost pressures persist, with liaison suggesting that some services firms – in industries such as hospitality – are having difficulty in fully passing on cost growth to prices, resulting in compressed margins. Easing in insurance price inflation, reflecting some easing of input cost pressures in this sector, also contributed to disinflation.

Inflation for goods and services with administered prices eased significantly over the year to the December quarter (Graph 2.22). Administered prices are those that are (at least partly) regulated or relate to items for which the public sector is a significant provider. The easing was partially driven by discretionary government subsidies for electricity, public transportation, and motor vehicle registration, as well as a one-off correction from the ABS to address errors in the treatment of child care subsidies made in earlier CPI releases.

Retail goods inflation picked up in the December quarter.

Inflation for retail goods picked up in the December quarter and is above its average rate of recent decades. The increase was driven by a pick-up in inflation for consumer durables items. The Black Friday sales appear to have had a smaller effect on price inflation than in 2023, possibly because they occurred later in the quarter. Despite the pick-up in inflation, information from liaison continues to note that subdued demand is making it difficult for firms to pass on higher input costs (in whole or in part) to final prices and that retailers’ final prices do not appear to be impacted by the increase in shipping costs over the past year. The recent depreciation of the Australian dollar could cause the price of imported consumer goods to increase in coming quarters; movements in the exchange rate pass through to import prices and then retail prices with some delay (Graph 2.23). It is too early to see an impact on either import or retail prices (see Chapter 3: Outlook).

Inflation expectations remain consistent with achieving the inflation target over time.

Survey and financial market measures of short-term inflation expectations have declined from their mid-2022 peaks, consistent with declines in actual inflation. Financial market measures of inflation compensation remain close to survey measures of medium- and long-term expectations; unions’ long-term inflation expectations have now declined to be close to the midpoint of the inflation target range (Graph 2.24). Our assessment is that long-term inflation expectations remain anchored at the target.

2.5 Assessment of spare capacity

We continue to assess that there is excess demand in the labour market, but progress towards better balance has stalled recently. However, there are indications that capacity pressures may have eased further in other parts of the economy.

A range of information – including labour market and labour cost data, business surveys and model estimates – continues to suggest the labour market is tight. Also, developments since the November Statement provide further evidence that the earlier easing in the labour market stalled over the second half of 2024 (see section 2.3 Labour market and wages). By contrast, our assessment is that the output gap, which reflects economy-wide capacity pressures, continued to move closer to balance over that period, consistent with the recent easing in underlying inflation.

A range of indicators suggest that the labour market remains tight relative to full employment and that conditions have either stabilised or tightened a little in recent months. Indicators of spare capacity in the labour market, such as the ratio of vacancies to unemployed workers and the share of firms reporting labour as a significant constraint on output, have stabilised in recent months after a period of easing (Graph 2.25). Similarly, the unemployment rate is little changed from the middle of last year, while the underemployment rate has fallen since then. These and a range of other labour market indicators are tight relative to historical ranges (although structural trends can affect the interpretation of these historical comparisons) (Graph 2.26). Based on this broad set of indicators, labour market conditions are assessed as being little changed from six months ago.

Model-based estimates also suggest that the labour market remains tighter than full employment, with both the unemployment rate and the broader hours-based underutilisation rate remaining lower than our estimates of their full-employment levels (Graph 2.27). The gaps between these series and their full-employment levels narrowed over the first half of 2024, but estimates suggest that no further narrowing occurred in the second half of the year. Estimates of the gaps for the September quarter are broadly consistent with the assessment in the November Statement; however, given the stabilisation we have seen in indicators of labour market conditions, our current estimate of the December quarter gap is larger than was expected in the November Statement. There is substantial uncertainty surrounding estimates of full employment, although each of the model estimates in the suite that we consider implies that the labour market is tighter than full employment. The possibility that our estimate of the sustainable level of unemployment (the NAIRU) is too high is considered in Chapter 3: Outlook.

Outside of the labour market, some indicators of capacity utilisation have eased a little. The NAB measure of capacity utilisation ticked down in January, particularly for goods industries, but remains above its historical average. This suggests businesses are still using their labour and capital resources at higher-than-normal rates to meet demand. Residential vacancies data show utilisation of the housing stock has eased slightly in recent quarters but remains elevated, consistent with subdued growth in housing supply over recent years. Retail vacancies data suggest utilisation of retail property has returned to its historical average, supported by demand in regional centres by large retailers (Graph 2.28).

A range of model-based estimates suggest the output gap was positive in the September quarter but continued to narrow. Recent outcomes for the level of output in the economy remained higher than estimates of potential output, suggesting that aggregate demand continued to exceed the capacity of the economy to sustainably produce goods and services (Graph 2.29). Nonetheless, estimates indicate the output gap continued to narrow in the September quarter, reflecting subdued growth in output relative to potential. This narrowing was broadly as expected in the November Statement.

Our judgement is that the output gap continued to move closer to balance in the December quarter. However, our assessment of the gap is uncertain. The range of model estimates for the output gap remains wide, reflecting differences in how individual models interpret the data. Given that demand and supply appear closer to balance, and the substantial uncertainty surrounding the estimates, it is becoming more difficult to assess the sign of the output gap.

Declining housing inflation and downward pressure on firms’ margins could help reconcile a tight labour market and strong unit labour cost growth with the recent easing in underlying inflation.

While there is uncertainty around our assessments of both the labour market and output gaps, the different signals they are giving about spare capacity over the second half of 2024 suggest that capacity pressures outside of the labour market may have eased, for example in the housing sector or within firms in some industries. Relatedly, it is possible that a decline in profit margins could reconcile strong unit labour cost growth with the recent easing in underlying inflation.

Declining housing inflation has been a significant driver of the recent moderation in underlying CPI inflation (see section 2.4 Inflation). This largely reflects weaker underlying demand for housing (see section 2.2 Domestic economic activity). The recent increase in average household size and easing in population growth have caused a slowing in rental inflation, while the decline in new dwellings inflation reflects the balance of demand and supply in that sector, rather than in the economy as a whole. As such, conditions in the housing sector can help to account for a decline in inflation despite continued tightness in the labour market.

Firms in the market sector have faced weak growth in demand and may not have been able to fully pass through increases in input costs. Firms’ labour costs, and some non-labour input costs, increased strongly over the past year, partly reflecting stronger conditions in the non-market sector. However, weak demand growth facing firms in the market sector may have limited the extent to which they can pass these costs through to output prices. While there are limited data on firms’ margins in aggregate, evidence from liaison and business surveys provides some support for margins having been compressed.

Alternatively, easing inflation could be telling us that the labour market is not as tight as implied by our central estimate of the NAIRU. Estimates of the extent of spare capacity in the labour market and broader economy are inherently uncertain. Our assessment draws on a range of information that supports the view that the labour market is tight. However, there is a risk that we have misjudged the extent of excess demand in the labour market. This possibility, and its implications for the outlook, is explored in detail in Key risk #1 in Chapter 3: Outlook.