Despite a significant lift in the inflation outlook the RBA Board decided to maintain its low key 25 basis point policy.
The Reserve Bank Board raised the cash rate by 25 basis points to 2.85% at its November meeting.
This result was widely predicted by the market and analysts.
Our view has been that the shock September quarter inflation report which showed a lift in core inflation of 1.8% (annual rate of 6.1%) compared to the market forecast of 1.5% and evidence of a widening of inflation pressures justified a 50 basis point move. That move would be to emphasise the Board’s commitment to returning inflation to the target range of 2–3%.
The Board recognised this unwelcome boost to inflation pressures by lifting the forecast for inflation in 2022 from 7.8% to 8.0% and the forecast for 2023 from 4.3% to 4.75%.
 The 2023 forecast increase is particularly troubling – a central bank which has a 2-3% inflation target and accepts that 4.75% inflation in the following policy year runs the risk of embedding an inflationary psychology for both businesses and employees making it more difficult to avoid an even more extended period of high inflation.
Forecast growth rates have been lowered to 1.5% (from 1.8%) in 2023 and 1.5% (from 1.7%) in 2024.
The forecast for the unemployment rate by year’s end is 3.5% (up from 3.4% in September) constrained by labour supply rather than demand, highlighting a risk to wages growth.
While the Statement did not provide a new forecast for wages growth recall that the August forecast is for only 3.6% in 2023 compared to the Westpac forecast of 4.5%.
When we raised our forecast for the November Board meeting to a 50 basis point move we increased our forecast terminal rate from 3.6% to 3.85%.
In response to the September Inflation Report we have raised our quarterly profiles for underlying inflation from 1.5% to 1.8% (September quarter); 1.2% to 1.8% (December quarter) and 0.8% to 1.2% (March quarter). This is not only because the September quarter proved to be higher than expected but also because the evidence from September was that inflation pressures were becoming more widespread, implying a deepening of inflation psychology.
Despite the Board not moving by 50 basis points today we think this higher inflation profile justifies maintaining the 3.85% terminal rate forecast.
Given that the Board chose not to respond to the inflation shock with more than 25 basis points we can only conclude that as rates continue to rise the increments will be 25 basis points.
We had expected that the 0.8% underlying inflation print we were anticipating for the March quarter would allow the Board to go on hold from March.
Now we expect that the March quarter Inflation Report which will print in late April will require a further rate increase.
Going forward we now expect 25 basis point increments in December; February; March and May.
We have not changed our growth forecasts for 2023 (1.0%) and 2024 (2.0%).
The growth momentum in the first half of 2023, while still slowing, is likely to be faster than the second half of 2023 where growth could stall completely.
The Board does recognise the risks of embedding inflation psychology in the system “The Board will continue to pay close attention to the evolution of labour costs and the price setting behaviour of firms.”
The final paragraph continues to emphasise that “The size and timing of interest rate increases will continue to be determined by the incoming data and the outlook for inflation and the labour market.”
Based on the decision to hold the increase to 0.25% at the November meeting this “incoming data” condition looks to be a very high hurdle.
Conclusion
The Board decided to stick with the 25 basis point path despite a significant lift in the inflation forecast for 2023 from 4.3% to 4.75%.
It now seems that the Board is prepared to await the impact of the series of hikes at that risk of embedding an inflation psychology in the system which would eventually require a much more damaging policy response.
Westpac retains its terminal rate forecast of 3.85% but now extends the length of the tightening cycle to May as inflation becomes more entrenched in the near term.
