The Reserve Bank of Australia (RBA) has joined other major central banks, including the US Federal Reserve and the Reserve Bank of New Zealand, in going harder in the fight against inflation.
On Tuesday, 7 June 2022, the RBA delivered a rate hike of 50 basis points, taking the cash rate to 0.85%. It follows a 25-basis point rate hike in May, which kicked off the RBA’s tightening cycle after headline inflation cracked 5.1% per annum in the March quarter. This most recent rate hike is the biggest in 22 years.
The consecutive monthly rate rises more than fully unwind the 65 basis points of emergency rate cuts the RBA implemented at the start of the pandemic. These back-to-back hikes, totalling 75 basis points, are the biggest in a two-month period since December 1994.
This hike means the cash rate is back above its pre-COVID level of 0.75%, as observed in February of 2020, just before the pandemic swept the country. On a backdrop of persistent high inflation, a strong labour market and solid economic growth, the Reserve Bank is clearly eager to quickly wind back emergency policy settings.
With the RBA flagging last month that more rate rises were likely, this recent rate hike is no surprise.
Our Group view was 40 basis points, although in recent weeks we had been signalling to customers the risk was of a 50 basis point move. The consensus view of economists was for 40 basis points and interest-rate markets only had a 54% probability attached to a 50-basis-point hike.
We see the rate hike of 50 basis points as the appropriate decision, given the potent backdrop of elevated inflation, strong economic growth and an extremely low rate of unemployment.
The danger is that inflation remains sticky. Inflation would have been harder to tame if the RBA failed to take strong action.
The RBA is nervous about elevated inflation pushing up inflation expectations, noting in the minutes from the May meeting that ‘it would be more difficult to return inflation to the target if the inflation psychology were to shift in an enduring way’.
Since the RBA last met in May, jobs data has revealed the unemployment rate has fallen further to its lowest level in almost 48 years, currently sitting at 3.9%. Inflation expectations have ramped up again to a record pace of just under 5%. Economic activity data has also revealed an economic expansion continuing solidly in the March quarter, despite the Omicron wave and weather disruptions.
Official wages data has remained slow to accelerate, with the topic barely receiving mention in RBA’s statement announcing the rate hike.
Moreover, a consideration of other information sources, such as the trends in business surveys and feedback from liaison surveys, suggests it is only a matter of time before the premier measure of wages growth (the wage price index) picks up considerably.
The need to act harder via the larger-than-expected move and the details in the statement suggest the RBA is becoming more worried about the strength of inflation.
RBA’s statement explains that near-term inflation is likely to be higher than expected a month ago because of higher electricity, gas and petrol prices. In the May Statement on Monetary Policy, the RBA forecast a peak in annual headline inflation at 5.9% later this year, with underlying inflation forecast to peak at 4.6% later this year. The latest statement suggests the RBA now expects inflation to peak even higher. Indeed, in a recent interview, the Governor said he expects inflation to peak near 7% at the end of the year.
To reflect this, we have also upgraded our inflation trajectory for this year and next, expecting the peak in the annual inflation rate to occur late this year near 7.0%, before it gradually declines over next year. The RBA too, expects inflation will decline to the 2%-3% target range in 2023, as the global supply problems are resolved, and commodity prices stabilise. It is not expected that inflation will return to the band until late 2023.
So, what’s next?
The RBA’s more aggressive stance and the revised outlook for inflation opens the door for another 50-basis point hike at the RBA’s next meeting in July. Indeed, at 0.85%, the cash rate is still providing stimulus to the economy and further hikes will be needed to bring inflation back under control.
We expect more tightening to follow the move in July. And we believe that interest-rate markets will remain convinced the RBA will need to be more aggressive.
The 30-day cash rate futures (as at 14 June) have a cash rate of around 3.75% priced for the end of this year, up from around 2.70% before the latest cash rate announcement. That is, markets expect the RBA to deliver a further 290 basis points of tightening before the conclusion of 2022.
These expectations are also reflected in swap and bond rates, especially shorter-dated bond and swap rates. It will take a run, perhaps somewhat prolonged run, of weaker economic data to convince the market that their expectations are too aggressive for 2022. That run of data may not materialise until later this year.
How high can the cash rate go? That is a difficult but important question. And one we need to consider and forecast amid heightened uncertainty. As the RBA gets closer to a cash rate that is no longer stimulatory, it will become trickier for the RBA to navigate cash rate policy. At a cash rate of 0.85%, the cash rate is still arguably very stimulatory. St.George anticipates that once the cash rate crosses over 1.50% (in August 2022), the RBA decisions will become more finely balanced.
Each successive rate hike will become more restrictive for households, given the level of household indebtedness in Australia. As the RBA highlighted, however, many households have built up large buffers, including paying off their mortgage faster than needed. The household savings ratio is also above the long-run average. Nonetheless, there will be households that will start feeling the stress.
Our preliminary forecast is for the cash rate to peak between 2 and 2.50% in the first half of 2023 – a rate that would see the household debt servicing ratio peak above previous peaks but there is greater variability around the peak in the cash rate at this early stage of the hiking cycle.
Much will depend on the transmission mechanism of monetary policy to the economy, including via the impact on dwelling prices and share markets.
Interestingly, the annual rates of inflation in New Zealand and Australia are closely correlated historically. The Reserve Bank of New Zealand (RBNZ) recently hiked back-to-back in 50 basis point moves – something that has not happened since the introduction of the Official Cash Rate in 1999.
When the RBNZ began hiking rates in October last year, their inflation rate was lower than the inflation rate in Australia when the RBA started hiking in May 2022. The economies are not identical, but one wonders whether the risks are that inflation proves peskier than the RBA would like. More tightening will slow growth, but because some of the key drivers of inflation are exogenous to Australia (that is, war in Ukraine and China’s zero-COVID strategy), inflation may still take some time to come back into the RBA’s band.