This week’s inflation data was in line with Westpac’s expectations. But what matters is whether the RBA was surprised. We do not think it was, and note that despite personnel changes, the RBA’s analysis and strategy have not changed.
This week’s inflation data were not a surprise to the Westpac Economics team and so did not change our view of the outlook for interest rates. As our Westpac Economics colleague Justin Smirk previewed last week, we had expected that base effects would lead the monthly indicator to print at 4% over the year to May. Clearly, the disinflation journey is becoming more difficult, and the RBA is becoming more nervous that its strategy may not work as planned. And as our colleague Pat Bustamante also highlighted recently, some recent state government budgets are not helping.
The real question is not whether we were surprised by the May inflation data but whether the RBA was. We can assume that the staff know how to account for one-off factors like changes in electricity rebates, or noise factors such as fruit and vegetable prices. Given their above-market forecast for June quarter headline CPI in the May Statement on Monetary Policy, we suspect that this week’s data were no surprise to the RBA, either. An ugly June quarter CPI release together with strong labour market data could tip the balance and force a rate hike, but this is not our base case and is not supported by currently available information.
In this context, the Deputy Governor’s speech last night was an important steer on the Bank’s view. While the speech itself was not about current developments, Deputy Governor Hauser reminded the audience that services inflation was in fact declining, and that ‘it would be a bad mistake to set policy on the basis of one number’. As well as highlighting the quarterly CPI, Deputy Governor Hauser pointed to retail sales and the labour market as key pieces of information yet to come.
Last night’s speech is part of a sequence of public events introducing the new Deputy Governor to the Australian audience. A previous milestone in that sequence, an interview in the Australian Financial Review earlier this month, also ruled out a potential policy risk in a way that has perhaps not been fully appreciated.
Recall that both the Deputy Governor and chief economist are new to the Bank and (compared with their predecessors) relatively new to Australia and Australian economic data. In addition, both the Heads of Economic Analysis and Economic Research will be vacating their posts shortly, for different reasons. Less well known (but evident from LinkedIn) is that the deputy heads of department in that group have also or are about to move to other roles in the RBA or BIS secondments. Given this decline in collective experience in reading the Australian economy, and particularly the country-specific nuances of the data (which all economies have), there was always a risk that the new leadership would take a different direction and adopt a different strategy and/or approach to reading the economy, for better or worse.
In our view, the Deputy Governor’s interview shows that this risk has not eventuated. The RBA continues to hold onto the priorities forged from earlier experience. The loss of experience has not translated into a loss of insight. In that interview, Deputy Governor Hauser spoke of importance of full employment, that the unemployment rate consistent with full employment could change, and that you needed to ‘test’ where it was. In other words, the RBA is continuing with the strategy articulated by the previous Governor to ‘protect the employment gains’ (Deputy Governor Hauser’s words) that were achieved in the aftermath of the pandemic. The refreshed Statement on the Conduct of Monetary Policy has solidified that strategy.
These insights are longstanding views of the Bank, first articulated before the pandemic in a pair of speeches in 2019 by the then Governor and the then chief economist. In the latter speech, I emphasised that ‘the level of the NAIRU [the sustainable unemployment rate around which inflation is stable] is an emergent property of the system. It is not baked in.’
While the nod to complexity theory in that reference to emergent properties might not be front of mind for the current leadership, the underlying analysis still seems to be. Further evidence of this recognition can be seen in the Bulletin article articulating the RBA’s approach to assessing full employment.
Related to this, this week’s speech by the Assistant Governor for Financial Markets highlighted that the RBA does still think that policy is currently tight. This speech was used as a vehicle to present updated estimates of the neutral nominal cash rate, noting that it, too, can and has changed. Again, we see a recognition at the RBA that these ‘star’ variables can shift.
A similar view of the likely neutral level of the interest rate structure informs our own view of the medium-term outlook. As we noted back in March:
In this context, one can interpret the Westpac Economics forecast for the cash rate at the end of 2025 of 3.1% as either neutral, with a neutral real rate a bit below 1%, or slightly below neutral with a higher neutral real rate. Given the uncertainties around both the outlook and the level of the neutral rate in any one period, we are agnostic about which interpretation turns out to be the right one. It might be that one will never be able to tell the difference.
The difficulty, though, is that the full-employment rate of unemployment seems to have fallen over recent years, while the estimates of the neutral interest rate point to it being higher than before the pandemic. The RBA’s recent commentary suggests that the former is more salient in the near term – consistent with wages growth already rolling over but contrary to some market commentary. But the latter limits the scope for rate cuts, when they do eventually come. A particularly bad scenario would be if both invisible benchmarks end up being overestimated. In that case, the ‘stars’ would collide to produce a period of overly high rates and slow growth.
