The vast majority of economists believe the unemployment rate is a lagging economic indicator, including in Australia.

Deutsche Bank isn’t convinced it is in Australia.

The bank sees the RBA lifting Australia’s cash rate early next year. Financial markets and an increasing number of economists see the next move as being a cut.

Stop calling Australia’s unemployment rate a lagging economic indicator, says Phil O’Donaghoe, Economist at Deutsche Bank.

In a note he’s recently released, O’Donaghoe argues that view is not appropriate for an economy such as Australia.

Here’s short snippet from the note explaining why.

Critics might suggest the labour market is a lagging indicator. It might be, for economies with large manufacturing industries where business cycles are driven in large part by shifts in inventory cycles. But for a service-oriented economy like Australia, the labour market acts much more like the economy’s ‘flywheel’, linking national income with consumption and investment.

Based on the chart below, showing the six-month change in Australia’s cash rate overlaid against the six-month change in Australia’s unemployment rate, O’Donaghoe says there has been an “intrinsic link between the RBA’s reaction function and contemporaneous labour market developments throughout the RBA’s inflation targeting regime”.

Deutsche Bank

With most leading labour market indicators continuing to point to solid hiring levels ahead, and given the view that Australia’s unemployment rate doesn’t actually lag the performance of the broader economy, O’Donaghoe, in contrast to financial markets and an increasing number of economists who believe the next move in Australia’s cash rate will be lower, says the next is still likely to be higher in the not-too-distant future.

“All this leaves us comfortable expecting the RBA’s next move in the cash rate to be a hike, we expect that in the first quarter of 2020,” he says.

“And we believe the hurdle to a lower cash rate remains higher than market appears willing to price.”

Markets are fully priced for a 25 basis point cut in the cash rate by early next year. Forecasters such as Westpac Bank, UBS and AMP Capital, among others, believe the RBA will cut Australia’s cash rate sooner in the second half of this year.

In recent commentary, the RBA has stated that “a sustained increase in the unemployment rate and a lack of further progress towards the inflation objective” could warrant a further reduction in the cash rate.

Australia’s unemployment rate currently sits at 5%, the lowest level since mid-2011.

Some analysts have expressed concern that a steep slowdown in the Australian economy in the September quarter last year, and the risk of a similar outcome in Q4 and early 2019, could see unemployment lift in the second half of the year given it will likely lead to a slowdown in employment growth.

The RBA has also nominated uncertainty towards the impact of falling Australian home prices, along with the outlook for the global economy, as other downside risks to its inflation forecasts.

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