Research Notes

Today, I want to discuss the challenges the Reserve Bank of Australia (RBA) faces in cutting rates. To do this, I’ll explore our model of Australian short-term interest rates, and how its components interact. A key focus will be the relationship between inflation and unemployment, and how this relationship makes it particularly difficult for the RBA to now lower rates.

Our model of the Australian cash rate is robust, explaining just under 90% of the monthly variation in the cash rate since the 1990s, when the cash rate was first introduced. The model’s components include core inflation (not headline inflation), unemployment, and inflation expectations.

Interestingly, statistical tests show that unemployment is even more important than inflation when it comes to predicting what the RBA will do with the cash rate. This is because of the strong, leading relationship between Australian unemployment and core inflation.

To illustrate this, I’ve used data from the past ten years up until December, which shows the relationship between unemployment and inflation in Australia. The data reveals a Phillips curve, where inflation tends to fall as unemployment rises. This relationship begins to work appears almost immediately, though there is a slight delay of about 3 to 4 months before its full effect is felt.

We look at the data from 2014 to the end of 2024. When unemployment is around 4%—which is where it has been for the past few months—we can predict that core inflation should be around 3.7%. Currently, core inflation is 3.5%, which aligns closely with what we would expect given the unemployment rate. This suggests that the current level of inflation is consistent with current unemployment levels.

Unemployment vs Inflation

2014 to 2024

However, the RBA’s target inflation rate is between 2 and 3%, with a specific target of 2.5%. To achieve this target, unemployment would need to rise from its current level of 4% to around 4.6% or 4.7%. Historical data, such as from 2021, shows that with an unemployment rate of around 4.6%, inflation can be brought down to 2.5%. Therefore, to reduce inflation to the RBA’s target, the unemployment rate would need to increase slightly—though not drastically. If unemployment were allowed to rise to around 4.6%, it would create enough excess capacity in the economy to put downward pressure on inflation, which would take about 3 to 4 months to materialise.

If the RBA were able to allow this rise in unemployment, inflation would decrease to around 2.5%, and the RBA could cut rates. Current rates are at 4.35%, and under this scenario, we could expect them to drop to the low 3.0% range perhaps even lower. This would represent a fall of around 100 basis points from current levels.

Unfortunately, the situation is complicated by fiscal policy. The current Treasurer, Jim Chalmers, has been expanding employment in sectors like the National Disability Insurance Scheme (NDIS) and other areas of the public service. This fiscal stimulus is preventing unemployment from rising to the level needed for inflation to fall. As a result, unemployment remains stuck at around 4%, and inflation remains too high for the RBA to cut rates.

In terms of job vacancies and other labour market indicators, we would have expected unemployment to rise higher by now. However, Treasurer Chalmers is committed to keeping unemployment low ahead of the election, which is why we find ourselves in this position.

The government’s fiscal policy, aimed at maintaining a low unemployment rate, is preventing the necessary adjustment to bring inflation down.

If I input the current levels of inflation, unemployment, and inflation expectations into our model, the estimated cash rate should be 4.45%. This is 10 basis points higher than the current cash rate of 4.35%.

The Australian Government seems intent on maintaining the unemployment rate at 4% ahead of the election. If it does so, Inflation will remain too high for the RBA to cut rates.

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Following the release of the Aged Care Taskforce report earlier this year, the federal government has recommended a number of changes to the cost of residential aged care, some will commence from the beginning of 2025 and the remainder expected to commence from 1 July 2025.

Over the next 40 years, the number of people over 65 is expected to at least double and the number of people over 85 expected to triple. A significant amount needs to be invested in the Aged Care sector, by both government and private sector, to be able to manage the growing numbers of older people needing care and support in their later years.

From 1 January 2025:

• Increasing the refundable accommodation deposit (RAD) maximum amount without approval from $550,000 to $750,000. This amount will be indexed annually.

From 1 July 2025:

• Introduce a RAD retention amount of 2% pa to a maximum of 10% over 5 years.
• Removing the annual fee caps and increasing the lifetime fee caps to $130,000 or 4 years, whichever occurs first.
• Introducing a means-tested hotelling supplement of $12.55 per day which is to be indexed.
• Removing the means tested fee and replacing it with a means tested non-clinical care contribution (NCCC). The daily maximum is $101.16 which is to be indexed.

From 2029/30:

• The government is looking to commence a phase out RAD altogether by 2035. A commission will be established to independently review the sector in readiness.

Grandfathering arrangements will protect anyone who enters care prior to 1 July 2025 under the “no worse off” principle to ensure they do not pay more for their care.

Comparison of current and new aged care costs

Current aged care fees

The Basic Daily fee continues to be paid by all residents without change.

The Hotelling Supplement is paid by residents as a contribution towards their living costs. It is a means tested payment calculated at 7.8% of assets greater than $238k or 50% of income over $95,400 (or a combination of both). The Hotelling Supplement is capped at $12.55 per day (indexed).

The Non-Clinical Care Contribution (NCCC) replaces the current means tested fee. The NCCC is a contribution towards the cost of non-clinical care services which will be capped at $101.16 per day (indexed). It is a means tested fee calculated at 7.8% of assets over $501,981 or 50% of income over $131,279 (or a combination of both).

The lifetime cap for the NCCC is increasing to $130,000 or 4 years, whichever occurs first, indexed twice per year. There is no longer an annual cap.

Any contributions made under the home support program prior to entering residential aged care will count towards the NCCC cap.

Who will likely pay more from 1 July 2025?

It is expected that at least 50% of people entering care will pay more for their care each year.

The below chart illustrates the expected changes for regular care costs (excluding accommodation costs and retention amounts) for individuals based on specific asset levels:

Should you enter residential aged care before 1 July 2025?

It depends. For some people, if they have an ACAT assessment and are eligible to enter residential aged care, then it would be best to seek advice from your Morgans Adviser on both the current and future cost as well as cash flow and cost funding advice.

Contact your Morgans adviser today to schedule an aged care advice appointment. Our expert team will be able to simplify the aged care system, guide you through Government subsidies, analyse payment options, create 5-year cash flow projections, and model the benefits of home concessions and future asset values for your beneficiaries.

Australian’s life expectancies are increasing over time. We can now expect to live longer - on average 5 to 7 years longer - than our parents or grandparents did.

The problem is that as we live longer, we also need to support ourselves for longer in retirement. This is compounded by the fact that, according to the Australian Bureau of Statistics (ABS), we are retiring earlier these days with the average age of retirement reported to be 56.9 years. Interestingly, the average age people intend to retire is 65.4 years.

According to the ABS’s May 2024 report:

• There were 4.2 million retirees
• The average age at retirement (of all retirees) was 56.9 years
• 130,000 people retired in 2022, with an average age of 64.8 years
• The average age people intend to retire is 65.4 years
• Pension was the main source of income for most retirees

In their Media Release supporting their 2024 retirement report, ABS’s head of labour statistics, Bjorn Jarvis, said: “While the average age people intend to retire has risen over time, it hasn’t changed much in the last 10 years. This average has been between 65.0 and 65.6 years for close to a decade, since 2014-15. On average, men intend to retire slightly later than women, but this gap is closing. In 2022-23, there was around half a year difference between men and women, compared to a year difference a decade ago.”

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Income at retirement

According to the ABS retirement report, a government pension or allowance was still the main source of personal income at retirement for 43% of retirees. This was followed by Superannuation, an annuity or private pension at 27%.

Factors influencing retirement

In 2022-23, the most common factors influencing older workers’ decision to retire was still financial security (36%) and personal health or physical abilities (22%). Around one in eight retirees (14%) said reaching the eligibility age for an age (or service) pension was a key factor.

Retirement planning

According to the ABS, 710,000 people intend to retire in the next 5 years, with 226,000 in the next 2 years. Will you be one of these people? If so, do you have the confidence your retirement plans will be enough to support you in retirement? Your Morgans adviser can review your retirement position and recommend strategies that will help you stay on track so that your retirement, when it happens, is an enjoyable stage of life. Already retired? We can help there too.

Contact your Morgans adviser today to schedule an appointment to discuss your retirement plans.