Gareth Aird, head of Australian economics at CBA, thinks the RBA will wait until June:
- The upcoming RBA May Board meeting is ‘live’.
- The RBA Board will discuss the case to raise the cash rate given the red hot Q1 22 CPI. A decision will also be made on reinvestment of the proceeds of maturing bonds.
- We expect the RBA to leave the cash rate target on hold, but recognise it’s a close call between on hold and a hike.
- We assign a 60% probability to the cash rate target left unchanged at the May Board meeting; a 30% probability to a 15bp increase in the cash rate target to 0.25%; and a 10% probability to a 40bp increase in the cash rate target to 0.50%.
- We expect the RBA to shift to an explicit hiking bias, which will set the scene for a June rate hike.
- We expect the RBA to announce that it will not reinvest the proceeds of maturing bonds (i.e. it will embark on quantitative tightening).
- The RBA will publish their full suite of updated economic forecasts in the May 2022 Statement on Monetary Policy (SMP) on Friday.
- We expect the RBA to significantly upwardly revise their near term profile for underlying and headline inflation and more modestly downwardly revise their profile for the unemployment rate (this may result in a small upward revision to their forecast profile for wages growth in 2023).
The coming week is a huge one for Australian financial market participants. The RBA May Board meeting on Tuesday comes in the wake of the incredibly strong Q1 22 CPI.
The strength and breadth of price rises in the inflation data means an RBA tightening cycle is imminent and the Board will discuss the case to raise the cash rate next week. As previously announced by the RBA, the Board will also make a decision about reinvesting the proceeds of maturing bonds that they hold on their balance sheet.
The CBA view on the RBA has been unchanged since 15 February when we surprised many market participants with our call that the RBA would commence normalising the cash rate at the June Board meeting. Our call was founded on two things:
(i) that the Q1 22 CPI would be a lot stronger than the RBA’s implied profile and therefore they would shift to an explicit hiking bias at the May Board meeting; and
(ii) data related to wages, particularly but not limited to the Q1 22 wage price index, would be sufficiently robust for the RBA to conclude that inflation was “sustainably within the target range” and therefore they would lift the cash rate at the June Board meeting.
The central scenario we proposed for lift off in June became the consensus call across the sell side of economists in early April following the April Board meeting.
The RBA Governor noted in his post meeting Statement accompanying the April Board meeting that, “over coming months, important additional evidence will be available to the Board on both inflation and the evolution of labour costs. The Board will assess this and other incoming information as its sets policy to support full employment in Australia and inflation outcomes consistent with the target”.
The RBA doubled down on this position in the RBA April Board Minutes (released as recently as 19 April). Indeed the Minutes added additional colour to the Governor’s previous statement on the importance of data over coming months (emphasis on plural). More specifically, the April Board Minutes contained this very important concluding paragraph (our emphasis in bold):
“Inflation had picked up and a further increase was expected, with measures of underlying inflation in the March quarter expected to be above 3 per cent. Wages growth had also picked up but, in aggregate terms, had been below rates likely to be consistent with inflation being sustainably at the target. These developments have brought forward the likely timing of the first increase in interest rates. Over coming months, important additional evidence will be available on both inflation and the evolution of labour costs. Consistent with its announced framework, the Board agreed that it would be appropriate to assess this evidence and other incoming information as it sets policy to support full employment in Australia and inflation outcomes consistent with the target.”
The May decision on the cash rate – stick or twist
A red hot Q1 22 CPI was a necessary condition for our call that the RBA would commence normalising the cash rate in June. But the Q1 22 CPI was even stronger than we anticipated and as such there is a very good case to lift the cash rate at the May Board meeting. Indeed a number of sell side analysts have shifted to a May rate hike as the base case because of the Q1 22 CPI print.
However, the RBA’s reaction function to hike the cash rate is not simply about the inflation data. The RBA have made it crystal clear that they will only raise the cash rate once they have concluded that inflation is “sustainably within the 2-3% target range”. And according to the April Board Minutes additional evidence is required on the “evolution of labour costs” to make that conclusion.
This additional evidence arrives in the Q1 22 wage price index (18 May) and the Q1 22 national accounts (1 June). That is, the data on labour costs that the RBA stated they want to see will be on hand at the June Board meeting. But it is not available ahead of the May Board meeting next week.
Therefore, if the RBA were to raise the cash rate next week they will have abandoned their framework for determining if inflation is “sustainably within the target range”. And they will have discarded their reaction function for the first rate hike that includes both inflation and labour cost data. In short, a rate hike next week would mean that the RBA walked away from their own published guidance of just a week ago in the April Board Minutes.
The focus on wages and labour costs in addition to inflation in the RBA’s reaction function carries a lot of merit. As the chart below shows, if the RBA hikes the cash rate at the May Board meeting the increase in rates will occur with annual wages growth, as measures by the wage price index, significantly lower than at the start of previous tightening cycles.
Put another way, whilst the recent inflation data has been incredibly strong, wages pressures at this juncture are not as strong as they have been at the beginning of previous tightening cycles. It may appear like the RBA is ‘behind the curve’ on the inflation front. But the wages data would suggest otherwise. And it lends a lot of support to the RBA’s desire to make sure the rise in consumer inflation is accompanied by higher wages growth before raising rates.
It is clearly plausible that the RBA hike the cash rate at the May Board meeting given the high Q1 22 CPI. But if that happens it will make it very hard for market participants to put any weight on RBA communication through the tightening cycle given their actions (i.e. a May rate hike) will not have married up with their words (i.e. the desire to see additional evidence on the evolution of labour costs).
On balance we think that the RBA will stick to its guidance from the April Board Minutes and leave the cash rate on hold at the May Board meeting. But it’s a close call. At next week’s meeting we assign a 60% probability that the Board leaves the cash rate target unchanged at 0.10%; a 30% probability that the Board raises the cash rate target by 15bp to 0.25%; and a 10% probability to the Board raising the cash rate target by 40bp to 0.50%.
The May decision on the reinvestment of the proceeds of maturing bonds
At the May Board meeting the RBA will make an announcement about reinvesting the proceeds of maturing bonds. We expect the state of the economy and the outlook for inflation and unemployment to result in the RBA announcing that it will not reinvest the proceeds of maturing bonds (i.e. they will embark on quantitative tightening).
The economic impact of the decision around the reinvestment of the proceeds of maturing bonds is small over the next year, given there are barely any maturities . But the optics would be important as it would mean that the RBA has tightened monetary policy at the May Board meeting even if they leave the cash rate on hold.
The tightening cycle
At this juncture we stick with our call that the first move in the cash rate will be 15bp in June to 0.25%, followed by another 25bp increase in the cash rate at the July Board meeting. We think a 40bp increase in the cash rate first up would put unwanted angst into a household sector that was under the impression, until recently, that interest rates weren’t going up until “2024 at the earliest”.
Notwithstanding, the inflation data is now uncomfortably high and it looks like a very close call between a 15bp hike and a 40bp hike at the June Board meeting on the basis that the RBA is on hold in May. We will look to the RBA’s communication next week for any signal on what may be delivered at the June Board meeting.
We remain of the view that the tightening cycle will be shallow and look for the cash rate to be 1.0% at end-2022 and 1.25% in early 2023, before the RBA pauses over the rest of 2023. Our estimate of the neutral cash rate is just 1.25% and as our central scenario we do not expect the RBA to take policy restrictive (though it is a key risk). The RBA wants the Australian economy to remain strong and their aim is to see annual wages growth reset upwards to around ~3½% (well above the pre-pandemic norm of 2¼%). We believe they will achieve this outcome on the basis that the tightening cycle is not aggressive.
The inflation data is red hot. But it is a lagging indicator and the RBA has yet to tighten policy. Rate hikes will work to slow the rate of inflation and cool demand in the domestic economy. We have been on the hawkish side of the inflation narrative right through the pandemic due to the incredible fiscal expansion financed by money creation. But we do not believe that inflation will be a problem domestically over the medium term.
The Australian household sector is one of the most indebted in the world. This means that rate hikes have a more powerful impact on our household sector than they do in almost all other jurisdictions. And the policy transmission mechanism from the cash rate to home borrowers is much more direct in Australia than it is for many other central banks as the bulk of our debt is floating. And most borrowers who are fixed are not fixed for longer than two years.
Finally we remind readers that the RBA cash rate before the pandemic was just 0.75%. This was not considered to be an ‘emergency setting’. For context, the US Fed Funds rate just prior to the pandemic was 1.5-1.75%. So the RBA cash rate will be back to its pre-pandemic level with just 65bp of tightening.
By contrast, Westpac’s Bill Evans now believes the RBA will begin hiking in May:
Last week we surprised most readers by forecasting a 40 basis point rate increase by the RBA at its June Board meeting.
There was no appetite amongst analysts for a rate increase at the May Board meeting and those expecting a move in June had settled on 15 basis points.
Our call came as quite a surprise.
Our reasoning was twofold:
- That we had lifted our forecast for underlying inflation in the March quarter from 0.9% to 1.2% boosting annual underlying inflation from 2.6% in December to 3.4%.
- In the April minutes the Board had elevated the actions of other central banks to centre stage in contrast with previous minutes where policy considerations focussed entirely on the Australian economy. Other central banks had already begun their tightening cycles and had moved or were expected to move in 50 basis point increments.
But while that expected lift in inflation was certainly sufficient to justify moving the cash rate immediately away from the emergency setting of 0.1%, the Governor gave some explicit guidance in his Statement following the April Board meeting: “over the coming months additional evidence will be available to the Board on inflation and the evolution of labour costs.”
That guidance was repeated in the April Board minutes that were released only one week ago.
This guidance was in line with the Board’s consistent commitment to needing to see formal evidence of upward pressures on wages growth.
We were confident that such evidence on wages would be available in May to justify that 40 basis point increase but the overwhelming justification for the rate increase would be the 0.8 ppt lift in annual underlying inflation (from 2.6% to 3.4%) which we expected for the March quarter.
My experience is that when central banks give explicit guidance about the next Board meeting we should listen intently.
That is why, while we expected that the Inflation Report would be sufficient to justify two “normal “rate hikes in both May and June the clear indication that the Board had committed to wait until June pointed to a “jumbo” 40 basis point move in June. The Inflation Report for the March quarter indeed printed a
high number – 1.4% (3.7% annual) for underlying inflation – considerably higher than our revised forecast of 1.2% (3.4% annual).
While annual underlying inflation is set to increase further over the next two quarters we assess that the March quarter will mark the peak in quarterly prints of underlying inflation.
We were closer on headline inflation, predicting a 2% increase, compared to the actual 2.1% and well above the market Consensus of 1.7%.
On seeing that number our thinking is now that it precludes the “luxury” of waiting for the additional information on the labour market and the RBA board will have to act on May 3.
Despite a higher print on underlying inflation for March than we had expected we think the move in May will be only 15 basis points to return the cash rate to 25 basis points and resume the likelihood that future moves will be at, or in multiples, of 25 basis points.
It is reasonable to ask why only 15 basis points when we previously favoured 40 basis points in June and the inflation print was significantly higher than our forecast.
The June decision would have had the benefit of fully preparing households and businesses for higher rates.
The Board would have signalled a very strong tightening bias at the May meeting; data on the labour market would have further strengthened the case by signalling a further tightening in the labour market and rising wage pressures.
The very strong tightening bias could be amplified in the May Statement on Monetary Policy, including significant upgrades to the inflation and wages forecasts.
By June the US Federal Reserve would have been on the verge of a second consecutive 50 basis point move.
For May, no such careful preparation is possible; the move will come only a week after the guidance that the Board intended to wait another month; and a jumbo first move would expose the risk of an excessive shock to confidence.
With 15 basis points coming in May we expect a further 25 basis points in June, achieving our earlier objective of a total of 40 basis points by June.
The RBA Board has more flexibility than the other central banks that have or are confidently expected to move to 50 basis point changes.
That means that it can take a more cautious approach by relying more on regular 25 basis points increments.
The RBA Board holds 11 meetings per year. The Federal Reserve and the Bank of Canada hold 8 meetings whereas the RBNZ holds only 7 meetings.
We agree that a serious case can be made for a 50 basis point move in June given that the Inflation report was such a significant surprise.
And the Board is likely to adopt a strong tightening bias following the decision to raise the cash rate in May.
But we think the Board will be aware of the likely terminal rate in this cycle and choose to retain its flexibility by preferring a series of 25 basis point moves over the course of the remainder of 2022.
This profile is unchanged from our forecasts which printed last week – 25 basis points in July and August to be followed by a further 25 basis points in October and November with the cash rate reaching 1.5% by end 2022.
We expect a further two moves of 25 basis points in February and May in 2023 for a terminal rate of 2%.
The excessive leverage in the household sector will act as the dominant constraint to the much more aggressive terminal rate (3.6%) favoured by the market.
Because this forecast change is essentially a redistribution of the targeted move of 40 basis points in June we have not changed our other forecasts from last week. There is no additional forecast table in this note.
My view is that the RBA will hike in June after the federal election once it has received all of the March quarter Consumer Price Index (CPI), wage growth and national accounts data.
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