RBA Board Hikes the Cash Rate by 0.25%

The decision to hike is the better policy option although not consistent with our interpretation of the implied guidance.

The Reserve Bank Board raised the cash rate by a further 0.25% at its May meeting, pushing the cash rate to 3.85%.

The decision came as a significant surprise to markets which had less than five basis points priced in. There have been a number of decisions in this tightening cycle that have been surprising to markets – the decision to hike by 50 basis points in June (instead of 25) and the decision to hike by 25 basis points in October (instead of 50 basis points.)

Markets and the majority of economists, including Westpac, had difficulty in following the Bank’s guidance.

In our bulletin last Friday we noted. “We have argued for the last six months that the peak in the current cycle will be the May Board meeting. Our preference was for that peak to be 3.85%, with a final 25bp hike in May based on the ‘here and now’ – record low unemployment and very high inflation – rather than relying on forecasts. We still believe this would be the better policy approach given the risks, but it appears to be out of line with the Board’s intentions.”

Our assessment of the Board’s intentions relied heavily on the guidance from the Governor’s recent speech pointing out the importance of the Inflation track being consistent with the Bank’s forecasts. The March quarter Inflation Report indicated that inflation was in line, (if not a little better), with that track.

He also emphasised the return to a policy of “to move interest rates multiple times then wait for a while to assess the pulse of the economy and move again if the situation warranted doing so … it is a return to that world.”

However, the Board had some doubts about the risks around the inflation profile. Although the revised staff forecasts have reduced the forecast inflation rate for 2023 from 4.8% to 4½% the Governor issued a strong warning that “services inflation is still very high and broadly based and experience overseas points to upside risks.”

Despite the improvement of inflation for 2023, the RBA left the inflation forecast for mid-2025 unchanged, at 3.0%.

The decision statement in highlighting that inflation is still too high – a point that we have stressed – gave a new prominence to “the importance of returning inflation to target within a reasonable timeframe”.

This clear emphasis on inflation means that the next “live” meeting is likely to be the August Board meeting when the Board will receive an update of the inflation path with the June quarter Inflation Report.

We expect that by August the Federal Reserve will be firmly on hold whereas for today’s meeting the Board will have been aware that the FOMC is almost certain to raise the federal funds rate by 25 basis points.

Our forecast for annual inflation in the June quarter is 6.3% (headline) and 6.1% (trimmed mean).

That should be an acceptable fall in inflation from 7.0% (headline) and 6.6% (trimmed mean).

By August we expect that the economy, particularly highlighted by the household sector, will be deteriorating. We expect that growth in the second half of 2023 will stagnate.

The cash rate is expected to remain on hold in August.

It is noteworthy that the Bank has lowered its forecast for growth in 2023 from 1.6% to 1¼%, most likely reflecting the downside adjustments to household spending that are already underway.

This weak growth environment in the second half of 2023 will be important to avert any further rate increases. A risk here is that the patience which the Governor has shown to only achieve the top of the target band by mid- 2025 might start to be questioned.

But the accumulation of the 375 basis point increase in rates over the past year, with the enhanced lagged increases associated with up to 35% of the total mortgage market moving from fixed to floating, means that even without further rate increases from the RBA overall average mortgage rates will increase substantially (possibly up to 1 ppt).

As expected, the Governor has maintained a tightening bias but has softened it somewhat from: “The Board expects that some further tightening of monetary policy may well be needed to ensure that inflation returns to target” to “Some further tightening of monetary policy may be required to ensure that inflation returns to target in a reasonable time.”

For now, “reasonable time” is accepted as mid -2025 and “target” is accepted as 3%. That may change but because our forecasts have the inflation target being reached at an earlier time (end 2024) due to our more pessimistic outlook for growth and a lower inflation forecast there will be no need to tighten policy or delay rate cuts.

That tightening bias is expected to hold at least until the August Board meeting.

We continue to expect that the first rate cut will come in the March quarter of 2024 with 100 basis points of cuts over the course of 2024.

Conclusion

The decision by the Board to respond to the current environment of full employment and very high inflation is the right policy decision and not relying on “forecast tracks” and previous policies of extended pauses.

However, we were surprised by the decision given the guidance in the lead up to today.

Going forward the weakness in the economy and slowing inflation is likely to eventually see the tightening bias fade; rates remain on hold for the remainder of the year with rate cuts beginning in the March quarter next year.