The RBA has announced a 25bps rate hike and, in a hawkish turn, has flagged an intention to hike significantly further over the next 12 months. Tim Toohey, Head of Macro and Strategy, provides his view.
The Reserve Bank of Australia (RBA) hiked interest rates by 25 bps today, more than the 15 bps that the market and Yarra had expected. This is a relatively modest attempt by the RBA to appear reactive to the stronger than expected inflation print during April and the RBA has also flagged there are more rate rises in store. Combined with still very strong commodity price data, this does provide some basis for a period of A$ appreciation.
The most interesting aspects of the commentary are that the RBA have now finally capitulated on their inflation forecasts and have now marked them materially higher. Recall that in 3Q21 the RBA believed Australian inflation would be 1.5%yoy by mid-22. The RBA commenced revising its inflation view in November 2022, however, after inflation printed at 5.1%yoy in 1Q22 the RBA’s have now adopted a relatively high inflation view vis-a-vis market economist forecasts. In the RBA’s words:
“The central forecast for 2022 is for headline inflation of around 6 per cent and underlying inflation of around 4¾ per cent; by mid 2024, headline and underlying inflation are forecast to have moderated to around 3 per cent. These forecasts are based on an assumption of further increases in interest rates.”
So the RBA is now saying that even factoring in market pricing for sharp increases in interest rates over the next 12 months, underlying inflation will still be in excess of the target in two years’ time. The RBA is essentially acknowledging they are significantly behind the game on where interest rates should be. The inflation overshoot is blamed mostly on global factors, but the RBA did also stress that local capacity constraints are now clear and wages are rising sharply, stating “the more timely evidence from liaison and business surveys is that larger wage increases are now occurring in many private-sector firms.” It is interesting what difference a high CPI print makes to the RBA’s spin on its liaison program. Prior to the CPI print the RBA was stating that wages were rising only modestly. Post the CPI print the RBA stated that wages were rising ‘rapidly’. Companies have been consistently calling out rising labour costs for many months, not just the past couple of weeks.
The irony is that the RBA has just obtained conviction that there is an inflation problem in Australia whilst global recessionary forces are building. Based on the shift in rhetoric and tone in the Statement, the RBA will now likely hike in 25 bps increments in June, July, August, and then again hike in November. One of these hikes will likely be 15 bps, likely the August hike, which would take the cash rate to 1.25% by November. At a minimum we would have to pencil in four hikes in 2023 on the basis of the RBA’s inflation forecasts, meaning the ‘terminal rate’ is likely to be north of 2.25% in 2023.
The RBA has also clarified its quantitative easing (QE) and quantitative tightening (QT) intentions. As noted, the RBA:
“…does not plan to reinvest the proceeds of maturing government bonds and expects the Bank’s balance sheet to decline significantly over the next couple of years as the Term Funding Facility comes to an end. The Board is not currently planning to sell the government bonds that the Bank purchased during the pandemic.”
So no QT, but a balance sheet that is expected to shrink quickly in the absence of the cheap funding provided to the banking system via the TFF.
The Statement signs off with hints of Dragi’s famous ‘whatever it takes’ comment, with the Statement declaring:
“The Board is committed to doing what is necessary to ensure that inflation in Australia returns to target over time. This will require a further lift in interest rates over the period ahead.”
The reality is that a cash rate at 35 bps is still a highly expansionary setting and post the hike our financial conditions index (refer chart) has barely changed. Conditions are still consistent with economic growth remaining 2.3% above Australia’s ‘potential’ rate of ~2.5%. That is, if the RBA wants to recalibrate monetary policy to something close to ‘potential’ economic growth then a 2.5% cash rate doesn’t quite get you there by itself. However, it’s the collateral damage that hiking quickly towards 2.5% would do to equities, bond spreads, and the A$ appreciation that would impact broader financial conditions that would do more damage than the rate hikes in isolation. It’s likely that it’s the A$ that will provide the biggest source of financial conditions tightening in coming months over and above the cash rate changes. Note the RBA is already looking for just 2% economic growth in 2023, so the intent is to take rates up sufficiently quickly to slow demand and gradually ease inflation pressures.
The RBA is starting late to a hiking cycle and flagging an intention to play rapid catch-up whilst hoping for a smooth economic growth adjustment. In reality the RBA should have just started hiking interest rates earlier and gradually raised rates in a forward-looking manner.