Today the Reserve Bank Board raised the cash rate by 0.25% from 0.10% to 0.35%.
The Governor issued his usual Statement at 230 pm and conducted a Press Conference at 4 pm.
The Governor noted that now was the right time to begin withdrawing some of the monetary support that was put in place to help the Australian economy through the pandemic.
The Board has made some significant changes to the forecasts that were released in the February Statement on Monetary Policy (SOMP).
The forecast unemployment rate at year’s end has been revised down from 3.75% to 3.5% and is expected to hold at that level throughout 2023. That is despite GDP growth expected to slow to a below trend pace of 2% (unchanged from February).
But of most significance was the upward revision in inflation. Underlying inflation is now forecast to reach 4.75% by end 2022 (currently 3.7%) compared to the SOMP forecast of 2.75% – a staggering uplift of 2 ppt’s in forecast inflation.
Underlying inflation is then forecast to fall back to 3% by mid- 2024 compared to 2.75% in the SOMP.
The task of reducing underlying inflation over that 18 month period from 4.75% to 3.0% overwhelms the previously expected task of holding it steady over the period at 2.75%.
We do not know where the Board expects underlying inflation at end 2023 but it seems entirely reasonable that the detailed forecasts to be released on May 6 will indicate that underlying inflation by end 2023 will still be above the Board’s target range of 2–3% (probably 3.25%)
This observation explains why the Board surprised today by lifting the cash rate a little further than the 15 basis points expected by the market and many analysts including Westpac.
It also signals that the Board should be prepared to “front load” its tightening cycle to convince households and business that it is committed to achieving that formidable goal of returning inflation back to the target band (admittedly to the outer limit) by mid-2024.
In the press conference the Governor revealed the interest rate path that was used to arrive at the forecasts.
He noted that the cash rate profile was 1.5%-1.75% by end 2022 and 2.5% by end 2023, most likely the base terminal rate.
He also noted that the choice of 25 basis points was a return to “business as usual” signalling that increments of 25 basis points might be considered the base case.
We are not convinced that the next move will be 25 basis points.
Consistent with our previous forecast that the Board would want to reach a cash rate of 50 basis points by June we expected 15 basis points in May to be followed by 25 basis points in June.
But that was before we saw the formidable challenge that the Board believes it has to return inflation to within the band over the next 2 years.
A larger increase in the cash rate than 25 basis points is likely to be seen by the Board as necessary to convince agents that it is serious about the challenge and to accelerate the unwinding of the emergency measures that saw 65 basis points of rate cuts in 2020.
We have chosen 40 basis points rather than 50 basis points purely because we expect that “business as usual” is increments of 25 basis points on a base of multiples of 25 basis points (in line with the practices of most other central banks).
It is better to slightly trim the largest expected increase in the cycle rather than reduce any subsequent moves to that 15 basis points that was rejected at today’s meeting.
We continue to disagree with the Board’s base case and the market’s expectation that the tightening cycle will extend into the second half of 2023.
We are surprised that the Board’s forecast is for the unemployment rate to hold at 50 year lows in the second half of 2023 despite growth slowing to a below trend 2% and continue to believe that the high leverage in the household sector will start to weigh on the economy as rates move above 150 basis points.
Apart from that large hike of 40 basis points in June to return the cash rate to 75 basis points we continue to expect the rate path we forecast before today’s announcement.
That is increases of 25 basis points in July; August; October and November with the rate reaching 175 basis points by year’s end instead of our previous 150 basis points.
That will be a level where the household balance sheet will come under some strain and the subsequent movements by the Board will be much more cautious – one hike of 25 basis points in February and another in May.
The Governor described a revised approach to assessing the outlook for wages.
He gave greatest emphasis not to the slow- moving Wage Price Index but to the results of the Bank’s liaison with businesses- 40% of the businesses responding to the liaison assessments described wage increases of above 3%. He confidently declared that wage growth is finally picking up.
It does not appear likely that a “disappointment” with the Wage Price Index that prints on May 18 or even the wages data in the national accounts (June 1) could divert his attention from the urgency of lowering that inflation rate back to the target band in 2023.
In moderating our rate view we continue to use the key approach that near term rate decisions will be heavily influenced by current forecasts whereas decisions further out are going to be impacted by the evolution of the data. For that reason, we see the need for some urgency in the near stages of this cycle but caution around the base assumption of four rate hikes in 2023 (or significantly more from the market).
The Governor also clarified the Board’s position on the balance sheet. It will allow maturing government bonds to run off without reinvesting the proceeds. It has not committed to accelerating the shrinking of the balance sheet by outright sales of bonds. Bear in mind that around $180 billion of term fund loans to the banks are due to be repaid in September 2023 (around $80 billion) and a further $100 billion in June 2024. That compares with around $350 billion of bond purchases during the pandemic. The Bank can reduce the build up in its balance sheet during the pandemic by around 35% without needing to sell bonds.
Conclusion
The Board is clearly on the path to winding back the extraordinary stimulus that accumulated during the pandemic and then moving rates back to a normal profile.
The Governor speculated that 2.5% cash rate (zero real) might be a reasonable target, but we will only know when we can assess the response of the economy to these policies.
Our view is that the early stages of the cycle are likely to indicate the Board’s commitment to the formidable task of bringing underlying inflation back from 4.75% to 3% over the course of 2023 and 2024.
In the early stages it is “safer” to move at a faster pace than in later stages when the build-up in rates will start to impact households.
We think that can be achieved with a terminal rate of 2.25% which will be reached late in the first half of 2023.
The high sensitivity of household balance sheets to rising rates will be the key constraint on the need for rates to move any higher.
