The Reserve Bank Board meets next week on June 6. The meeting is live in that the case for a further rate increase is likely to be seriously discussed. However, we expect the Board to decide to hold the cash rate steady at 3.85% while continuing to emphasise its tightening bias.
The line: “Some further tightening of monetary policy may be required to ensure that inflation returns to target in a reasonable time frame, but that will depend on how the economy and inflation evolve” is likely to be repeated in the Governor’s statement following the meeting.
Note that the qualifier “may be required” was used despite the Minutes for the May meeting showing that the Board had become more concerned about range of issues including: immigration; house prices; and the inflation forecast being to only reach the top of the target range by mid-2025.
Since the May Board meeting the Governor has been publicly voicing more concerns about inflation risks, particularly relating to wages.
However, it seems unlikely that he will choose to use stronger language than we saw in May. For example, stronger language would see “may be required” be replaced with “will be required”.
There are still too many uncertainties for him to choose to strengthen the guidance.
In particular, the March quarter national accounts are set to be released on June 7 – the day after the Board meeting.
The May Board Minutes correctly highlighted concerns about household spending, members observing that “the outlook for consumption was weak.”
Consumer spending slowed from 1% in the September quarter to 0.3% in the December quarter. Westpac notes that real retail sales contracted by 0.6% in the March quarter (compared to a decline of ‘only’ 0.3% in the December quarter) and vehicle sales have been flat while we have seen a marked deterioration in Westpac’s debit and credit card activity.
Overall we are expecting consumer spending to be flat in the March quarter, held up by services spend, but there are clearly some downside risks. Even a flat outcome will be a disturbing result and something that the Board should treat with care.
Due to upside surprises for construction and equipment investment, the headline GDP result is still expected to be positive but come in at a tepid 0.2% growth for the quarter – only just avoiding a contraction. With uncertainty, particularly around net exports, inventories and services spend, the Board should be deliberating on the basis that a negative GDP result is entirely possible.
With Board meetings every month and given the rapid increase in rates since May last year waiting for the national accounts report seems to be the most prudent approach.
This report will also provide important updates on other areas of concern for the Board, including the savings rate; productivity; labour costs and inflation.
Other data since the May Board meeting also emphasises uncertainty – most notably, a surprise lift in the unemployment rate in April, from 3.5% to 3.7% . We assess that this increase has been due to seasonal anomalies in April associated with the timing of Easter but, once again, it would be prudent for the Board to wait for further information to clarify the employment data.
The quarterly growth rate of the Wage Price Index held at 0.8% in the March quarter – the same as December, which had slowed from 1.1% in the September quarter. That came as a surprise to most commentators who were expecting a modest lift in wage momentum. The contribution from wages set by ‘individual arrangement’ – a highly cyclical segment – also slowed. Against this, the just-announced 5.75% increase to the national minimum and award wage rates is higher than last year’s average increase of 4.7% (and looks to be materially higher than Treasury’s assumptions) but is broadly in line with what our aggregate wage growth forecasts were already implying for 2023.
The monthly inflation indicator showed an increase in annual inflation to 6.8% up from 6.3% in March. The average monthly increase in the indicator in the first three months of 2023 was 0.1% compared to the 0.8% for April. A significant part of the increase in annual inflation was explained by fuel – reflecting the temporary halving in excise duty introduced in April last year. However, the strong April month rise came from rents; house purchase costs; and holiday travel and accommodation.
Because the Board has discussed the stickiness of services as an issue offshore the 7.2% increase in travel and accommodation might raise a few eyebrows but this highly volatile series follows +27% in December; and -7.2%; -14.6%; and +1.5% in the following months. Some of the April rise is also clearly seasonal – even with COVID effects, the monthly history back to 2019 shows a consistent pattern of price gains in April (averaging +7%) and falls in May (averaging –5.7%).
Volatile month to month moves mean the April result is not sufficiently definitive to trigger an immediate rate response. The full picture for inflation in the quarter will be released on July 26, ahead of the August Board meeting.
We suspect the Board is still not recognising the full extent of the impact of rate tightening to date. It discusses the lagged effect of the rate hikes since May last year but does not set out just how much of this is yet to come through. As at March (the latest month available), the average mortgage rate on outstanding loans has only lifted by just over 225bps since the start of the cycle, despite a cash rate rise of 325bps (with a further 50bps in tightening since then). About 25bps of this gap reflects lags in the pass-through of official rate moves to borrowers on standard variable rates. The rest reflects the high proportion of borrowers, around 30%, on fixed rate loans.
Many of these borrowers are still only rates of 2-3% due to extraordinary fixed-rate offers that were available when the RBA was providing lenders with three-year money at 0.1%.
As these fixed rate loans mature and are rolled over into floating rate at 5-6%, the average mortgage rate will continue to increase. The combination of lagged effects from official passthrough and this roll-over effective mean average mortgage rates will lift close to 100bps by year end, with more modest rises coming in 2024. In effect even once the RBA goes on hold mortgage borrowers on average will still see significant effective rate increases through the rest of this year and next.
Another concerning drag on households has been the surge in rents. There appears to be angst in the Board about the impact of sharply rising rents on inflation but our estimates indicate that wider housing cost inflation is likely to moderate as growth in construction costs cools rapidly – outright price declines even possible given the downturn in new residential building (note the 8.1% drop in dwelling approvals in April, now down a steep 24.1% for the year).
With around 30% of households being renters, sharp increases in rents are likely to further constrain household spending. That said, rents are largely a transfer between households – hence rises will provide some offset to the cost of living and interest rate pressures bearing down on other households.
Overall, these developments still make a strong case for the Board to take an extended pause, to get a clearer picture on demand and inflation, and to allow the automatic further increases in average mortgage rates and the financial squeeze on renters to work their way through the economy.
From the perspective of inflation, weakening demand will put significant downward pressure on inflation and eventually ease the demand for labour and therefore the more persistent pressure on services inflation.
We remain comfortable with our 4% inflation forecast by year’s end with no need for any further increases in the cash rate.
Markets are now pricing in a 100% chance of a further rate increase by August. The odds should probably be more evenly balanced than that given the extraordinary in-built lags in the system. Market pricing has already been wildly out of line on three occasions in this unique cycle: in June, October and May.
In terms of the global policy backdrop, FOMC speakers have effectively ruled out another move by the FOMC in June but markets are already speculating on a July move. In this cycle the FOMC is using a less effective instrument (the federal funds rate) than the RBA’s cash rate given that US household borrow is typically on fixed-rate terms of 20-30 years – the federal funds rate operates primarily through business lending; credit card rates and asset market channels rather than directly through the cash-flow of the household sector. In this cycle, US households have been more resilient than we are seeing in Australia, allowing the RBA to achieve its objectives with a more moderate tightening cycle. Despite the significant gap that is opening up between the federal funds rate and the cash rate, the RBA should not be seeking to chase the FOMC.
Conclusion
There is too much uncertainty for the RBA Board to raise the cash rate again next week. In particular the outlook for household spending is very worrying especially with inbuilt lags associated with this unique cycle. An extended pause to allow full evaluation of these lags is the best policy.
