Following an expected substantial lift in underlying inflation for the March quarter and a fall in the unemployment rate from 4% to 3.8% in April we expect the RBA will decide to lift the cash rate by 40 basis points at its Board meeting on June7.
Inflation and the Labour Market
Yesterday we released our forecast for the March quarter Consumer Price Index. This Report is due to print on April 27.
We have lifted our forecast for underlying inflation in the quarter from 0.9% to 1.2%.
At 1.2% the annual rate will be 3.4%. That represents an increase in the annual rate from 2.6% in the December quarter and from 2.1% in the September quarter.
An increase in the annual rate of 0.8 ppt’s over one quarter and 1.3 ppt’s over two quarters is matched only by 2007/08 in recent times.
In 2007, annual underlying inflation increased from 2.8% in the June quarter and 2.9% in the September quarter to 3.6% in the December quarter (and 4.2% in the March quarter).
Following the news on the December quarter inflation the RBA responded with 25 basis point rate hikes in both February and March 2008 bringing the rate to 7.25% (significantly above neutral).
That was despite it being quite clear to markets that the world was on the brink of a major financial crisis, (later in 2008 and early 2009 the RBA was obliged to cut the cash rate back to 3% from 7.25%).
This episode just emphasises the sensitivity of the RBA to large movements in underlying inflation.
It is now generally accepted that the RBA will begin the tightening cycle on June 7.
Because the current cash rate is an unusual 10 basis points we had expected that the first move would be 15 basis points to restore the cash rate to 25 basis points.
However, given our expectations of a rapid further increase in underlying inflation and a forecast fall in the unemployment rate for April (to print on May 19) to a 48 year low of 3.8% we expect the Board will decide on a bolder initial lift in the cash rate.
We accept that there is a risk that the Board would be concerned about such a large move at the beginning of the cycle with implications for Confidence.
A possibility might be for a more cautious 25 basis point lift in June to be followed by the 40 basis point move in July.
However, we anticipate that market and media expectations will shift towards a 40 basis point move over the next six weeks and the anticipated shock to confidence will be contained.
This decision will be in the context of the Federal Reserve Open Market Committee (FOMC) having lifted the federal funds rate by 50 basis points on May 4 and the certain prospect of a further 50 basis point increase at the June FOMC meeting which is scheduled for the week after the RBA’s June Board meeting.
Both the Bank of Canada (April 13) and the Reserve Bank of New Zealand (April 13) have recently opted for 50 basis point increases in their policy rates.
The April Board Minutes
On April 12 the minutes of the Reserve Bank Board meeting for April noted” Central banks in many advanced economies, including the United States, had responded to higher inflation by increasing interest rates from their historically low levels and had signalled that further increases were likely.”
This quote was significant because it figured at the beginning of the key section in the minutes “Considerations for monetary policy”.
In the minutes of earlier meetings this key “considerations” section only covered issues around the Australian economy. As noted in his speeches, in the last few years the Governor saw Australia’s position as being quite different to other developed economies.
Including reference to the actions of other central banks in such a prominent position in the minutes indicates the Board is now taking a more global approach in responding to Australia’s surging inflation rate.
Market Pricing
Markets are currently priced for the cash rate to reach around 40–45 basis points by the June meeting.
At present that is made up of around 10 basis points at the May meeting and a further 30 points at the June meeting.
Our “golden rule” for tracking central banks is that their guidance beyond three months is dependent on their forecasts. If you have a different set of forecasts to the central bank then when your forecasts prove to be correct the central bank will have to respond in a way that will be consistent with the conditions and contrary to their current guidance.
It was that thinking that prompted us to be “very early leavers” from the “no hike till 2024 “Club in June last year; and the “no hike till 2023” Club in January this year.
But when the Bank is giving very near-term guidance then we listen intently.
The minutes noted that “Over coming months, important additional evidence will be available on both inflation and labour costs”. The labour cost information will be available on May 18 (Wage Price Index) and May 19 (April Employment Report).
That guidance is sufficient for us to accept that the RBA will wait until June for the first move.
At the May 3 meeting we expect the Board will adopt a clear tightening bias in anticipation of a move in June.
That should be sufficient to encourage the market to maintain its expectation that, despite steady policy in May, the cash rate will reach 40–50 basis points at the June meeting.
Our research shows that the RBA is influenced by market pricing near the time of a Board meeting. If the market persists with a 40 basis point expectation it is unlikely that the Board would persist with a 15 basis points move.
The Profile of the full Cycle-Terminal Rate is Unchanged at 2% We expect that the RBA will “bring forward” the tightening to accelerate the unwinding of the emergency cuts in 2020 (65 basis points) given that the emergency has passed; inflation is rising rapidly and the unemployment rate has reached 48 year lows. We do not envisage a higher terminal rate in the cycle.
That stays at 2% and is still timed for mid-2023 (May rather than June).
It is interesting that, at this stage, the RBA may have a similar target in mind. In the April Financial Stability Review a centre piece of the Review was a scenario analysis of the sensitivity of household balance sheets to a 200 basis point lift in the variable mortgage rate.
Under our previous scenario of a 15 basis point lift in June we expected 25 basis point increases to follow in July and August, with a pause in September to be followed by two more increases of 25 basis points in both October and November. With the exception of the larger increase in June the rest of the profile remains in place with the rate by November reaching 1.5% rather than 1.25%.
The expected pause in December also remains with two 25 basis point hikes in February and May.
Compared to the previous profile the cash rate reaches 1.5% by year’s end, up from 1.25%, while there are only two increases of 25 basis points in February and May compared to the three increases in the previous profile.
How dependent is this profile on the Inflation Report?
We always endeavour to provide readers with internally consistent forecasts.
The lift in the inflation forecast is consistent with a more decisive response from the RBA.
Recognition in the minutes of the actions of other central banks also had an impact on this change of view.
As discussed above, the Bank might respond with a 25 basis point move in June to be followed by a 40 basis point move in July.
That strategy is a genuine possibility but does not represent the better policy option.
