I was enormously relieved to see a survey released this week showing that the consensus of Australian economists is that rates will begin to fall in February next year. The reason I was relieved is because I found that I'm not in the consensus; in fact, I think it's practically impossible for rates to fall in the first half of next year. I've got rates beginning to fall, perhaps in the third quarter of next year. The reason for that, as you will see as we go through the presentation, involves some awfully clever decisions made by Jim Chalmers, stemming from the fact that he has a PhD in politics but no PhD in economics. Otherwise, he might have made those decisions differently.
First, I want to touch on the US employment report from Friday. The US employment number last week surprised on the upside, with growth in payroll jobs at 159,105 which was higher than consensus.
Importantly, in terms or model for the Fed funds rate, it reduced unemployment. Falling unemployment pushes up the equilibrium level of the Fed funds rate. I've shown before that the Fed will cut rates as long as the year-on-year rate of growth of employment is below the long-term median.
In today's slides, I've focused on what's been happening this year rather than the full decade. Here, you have a chart of U.S. payroll employment year-on-year growth. Historically, the Fed tends to hike rates when year-on-year employment growth is stronger than the long-term median and tends to cut when it's lower than the long-term median. In August, year-on-year U.S. Employment growth rate fell below the long-term median to 1.55%, just below the long-term median growth rate of 1.6%. This set up the Fed to cut rates by 50 basis points.
Does the September employment number stop the Fed from giving us more cuts? No, even though it's a stronger-than-anticipated number, it's not a substantial increase. Employment growth is still lower than the long-term median. Moving to our model of the Fed funds rate, we find that the Fed has been able to bring down inflation because the Fed funds rate has been much higher than the Australian cash rate. In the previous cycle, back in 2007, The Fed raised rates to exactly the same level, 535 basis points, while we raised rates to 475 basis points. This time, they raised rates to 535 basis points, while we only reached 435 basis points, almost half a percent below where we were before.
When we look at our model of the Fed funds rate as opposed to where the Fed funds rate actually is, their estimate is 3.4%. This is 140 basis points lower than the current rate. So, there’s plenty of room for the Fed yet, which is why they will continue to cut rates next month and the month after. We anticipate a cut of 25 basis points in November and a further cut of 25 basis points in December.
Let's examine the situation in Australia. We have a much lower cash rate, and our cash rate model suggests it should be much higher than our Fed Model, swinging above and below the equilibrium cash rate. The reason for this is that core inflation is much higher in Australia, about 70 basis points higher, so our model's equilibrium level is about 70 basis points higher than in the U.S.
The major reason our interest rates didn’t go as high is due to conditions set by Jim Chalmers, who imposed limits on the RBA at the beginning of this current government. These conditions allowed the RBA to focus on bringing down inflation but restricted them from raising rates to a level that would jeopardise employment gained in the previous expansion. As a result, the RBA only reached a peak level of 4.35%. The problem with not being able to raise rates higher is that it prevents generating real interest rates high enough to exert downward pressure on inflation.
Thus, the upper limits set by the Treasurer have made it much more difficult for the RBA to reduce inflation. This, in turn has made it more difficult for the RBA to cut rates.
Moving on to fiscal policy, we see a table from the budget papers that will be updated in December. Jim Chalmers has been talking about the surpluses he achieved, which were indeed significant due to historically high commodity prices. However, as commodity prices fall, he is projecting deficits. These are: $28 billion in 2024-25 and $42 billion in 2025-26, resulting in 1.1% and 1.5% deficits of GDP, respectively. This increased spending provides stimulus to the economy, getting in the way of the RBA's efforts to raise interest rates enough to combat inflation.
Therefore, it makes it extremely difficult for the RBA to bring down inflation this year, next year, or even in the second half of next year. I believe that with luck, circumstances might allow them to cut rates in the second half of next year, but not before August 2025.
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