RBA: Staring Down Inflation

Published on June 7, 2022
SGH Insight
“The Board expects to take further steps in the process of normalising monetary conditions in Australia over the months ahead,” Governor Philip Lowe said in his post decision statement.
In practice, this means the RBA likely wants to raise the official cash rate another 100bps this year. Another 50bps could be in the offing when it meets July 5 before it steps down to 25bps moves at a couple of its five remaining Board meetings between August and December. That would give the Bank an opportunity to see somewhat backward looking but key quarterly inflation releases due July 27, and October 26.

Market Validation
Bloomberg 6/21/22

Australia’s central bank chief Philip Lowe
said interest rates are likely to rise by 50 basis points at
most in July, prompting money markets to scrap bets he would
track the Federal Reserve with a 75 basis-point move.

Lowe was asked directly after his speech whether 75 basis
points was on the table and responded that, like this month, the
board would only be considering a rise of 25-to-50 basis points
in July.

The Reserve Bank of Australia this week supercharged its hiking cycle, raising rates 50bps Tuesday to 0.85% as it warned of further increases. The Bank plans to push rates toward neutral by the end of next year, though at his May post meeting conference, Governor Phil Lowe would not be drawn on where neutral is.

The RBA’s rates pivot and its determination to avoid higher embedded inflation expectations prompted this week’s 50bps hike. It was accompanied by a 50bps hike in the rate on Exchange Settlement balances to 75bps, maintaining the 10bps gap between the cash rate and the rate used by banks to settle interbank transactions.

The central bank is unwinding Covid-related emergency policy settings with urgency, amid a significant increase in its inflation rate, beyond 5%, that blindsided the bank and threatens to rise further before it eventually tracks back toward the 2-3% target range. The immediate path forward is clear:

“The Board expects to take further steps in the process of normalising monetary conditions in Australia over the months ahead,” Governor Philip Lowe said in his post decision statement.

In practice, this means the RBA likely wants to raise the official cash rate another 100bps this year. Another 50bps could be in the offing when it meets July 5 before it steps down to 25bps moves at a couple of its five remaining Board meetings between August and December. That would give the Bank an opportunity to see somewhat backward looking but key quarterly inflation releases due July 27, and October 26.

Lowe has been at pains to reiterate that the economy’s strength and inflation surge have rendered extraordinary monetary support no longer appropriate. The board is committed to getting back to a “normal” rates setting following the pandemic, he said.

Lowe also believes the Australian economy can withstand higher rates. Gross domestic product grew 0.8% from the final three months of last year and the annual rate was higher-than-expected at 3.3%. The Bank has forecast a healthy 4% growth rate this year and 2% next year.

It will be carefully watching household data over coming months to see whether the financial buffers it believes savers built up over the pandemic continue to buoy consumption. Broadening price pressures have been spurred by strong domestic demand and capacity constraints. Australians will also be hit by an electricity-price hike after the Australian Energy Regulator announced it will raise electricity bills by 4-14% starting July 1. The move reflects steep rises in wholesale electricity costs as generator outages and higher coal and gas prices stemming from disruptions to global energy markets.

Still, inflation is not as high as in most other advanced economies, and though the Bank recognizes supply chain disruptions and the war in Ukraine account for much of the price increases, they are worried domestic factors that are contributing to price increases, could keep inflation elevated even after supply side factors abate.

Chief among their concerns are wages pressures. The RBA is particularly focused on cooling Australia’s hot labor market, which is the tightest in 50 years. The unemployment rate was 3.9% in April while inflation is running at 5.1%. The latest wages data likely tipped the RBA’s hand on this week’s bigger increment despite expectations broadly centered around a 40bps move.

The Bank was listening to businesses telling them about having to pay consistently higher wages to keep employees. Even ahead of hard data, the ‘liaison’ feeds prompted a dramatic about face by the RBA despite its earlier guidance that it did not expect to need to hike rates until 2024. Official quarterly growth data confirmed the liaison feed and showed companies’ wage bills climbed 5.5% in the first quarter from a year earlier.

The RBA is aiming for a neutral cash rate which is viewed to range widely up to 2.5%. (The Bank applies a technical forecasting assumption to its projections based on an average of market and economists’ rate path expectations). The RBA has no idea yet if it will need to push rates into restrictive territory. That will be determined by, among other data, productivity growth, which has been declining for years though it is clear officials are not holding their breath for a sharp turnaround in that trend.

The Bank’s framework is also more flexible than other major central banks. It “intentionally allows for flexibility and some variability in inflation from year to year” so that the inflation rate tracks back to the target range of 2 to 3% over time. It is seeking an orderly inflation slowing over its forecast horizon and it will be 2024, before the rate even reaches near 3%, the top of its inflation target band. This provides space to revert back to smaller rate hikes.

What Lowe and his board will not tolerate, is a level shift higher in inflation expectations that compromises their ability to reach target over time. Officials are worried expectations could become embedded at a higher level and they want to retain options to push the cash rate higher into neutral territory if they need to. Returning inflation to the target “would be harder to achieve if the inflation psychology in Australia were to shift in a durable way due to the recent higher inflation outcomes,” the May minutes said. Ongoing concerns about the stability of inflation expectations would push the RBA toward another large hike at the July meeting.

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