Bill Evans of Westpac is serenely cheering on the Lunatic RBA. He needs to wake up. This is a rerun of the errors of early 2008 when a global recession and ginormous deflationary shock were hurtling toward Australia and the Lunatic RBA hiked its way to the moon chasing supply-side price rises it could not affect.
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The Reserve Bank Board meets next week on July 5.
We expect the Board will decide to lift the cash rate by 50 basis points from 0.85% to 1.35%.
We assess the neutral zone for the cash rate at 1.5-2.0%.
Consequently, even after that move the cash rate will still be below the “neutral zone” and in stimulatory territory.
Following the May Board meeting when the cash rate was raised by 0.25% the Governor’s subsequent press conference left listeners with a clear impression that the Board was likely to follow a path of “steady” 25 basis point movements.
While we acknowledged that signal from the press conference, we argued that the time was right to predict the “right policy” rather than follow the guidance.
The “right policy” was to make a larger move when rates were clearly in the stimulatory zone; inflation was well above the target zone; and the unemployment rate was at a 48 year low.
We argued for a 40 basis point increase at the July meeting, while acknowledging that a 50 point increase was fully justified by our arguments.
We advocated pushing hard on rates at the beginning of the cycle when the risk of overtightening was low. It was really important to send a decisive signal that the RBA was committed to returning inflation to within the target band in the medium term.
Consequently, we were encouraged by the decision at the June meeting to raise the cash rate by 50 basis points. Note that the last time there was a 50 basis point increase was in February 2000.
The Minutes of the June Board meeting describing the decision to move by 50 basis points supported our approach; “The main argument for an increase of 50 basis points was that the level of interest rates was still very low for an economy with a tight labour market and facing a period of higher inflation”.
The Minutes also pointed out that even after a 50 basis point move “the cash rate would be highly stimulatory”.
The policy of a 25 basis point increase was discussed at the June meeting.
“The argument for an increase of 25 basis points was that a sequence of 25 basis point moves represented a steady approach to withdrawing monetary policy stimulus and that this was appropriate in an uncertain environment”.
The impotence of a predictable, steady sequence of 25 basis point moves was demonstrated during the housing bubble period in the US. Between June 2004 and May 2006 Chairman Greenspan’s FOMC raised the federal funds rate at every meeting by 25 basis points. That steady , predictable policy did little to dissuade speculators about the FOMC’s commitment to maintaining stability.
My interpretation of the “uncertain environment” is that in due course, when rates are higher, that consideration will be relevant. Once policy is near the top of the “neutral zone” the impact of policy on the economy does become more uncertain and caution is warranted.
The other benefit of the 50 basis point move at the June meeting was seen to be “there is a heightened risk of persistently high inflation, especially if expectations of higher inflation become entrenched.”
That concern around inflationary expectations stands out as a key consideration not only for the RBA but also for all central banks.
A “steady” path of 25 basis points would certainly have much less “shock effect” on the assessment of the commitment of the RBA to containing inflationary pressures.
So, now that the Board has clarified its position on the best approach to policy it would seem quite clear that with the cash rate at only 0.85% a second decisive move of 50 basis points is the appropriate policy.
The Minutes noted the “evolving risks to household consumption” including the dampening effect of higher prices and interest rates on consumption and the impact of higher interest rates on house prices. But this concern was tempered by the accumulation of large financial buffers and a very high current household savings rate.
These observations, along with the current boost to spending from the reopening effect, all point to the Board having considerable confidence from the high frequency data that a second “large” rate increase will not significantly damage the economy in the near term.
From our perspective the issue becomes one of when it will be appropriate to scale back the rate hikes as uncertainty around the impact of higher rates becomes more real.
We do not think policy will reach that stage until after the Board meeting in August.
This meeting will follow the release of the June quarter Inflation Report. We expect annual underlying inflation (Trimmed Mean) will print 4.2% (up from 3.7%) with upside risks while annual headline inflation will print 5.9% up from 5.1% – with a likely trajectory towards 7% by year end.
Based on our forecast for the July meeting the August decision will still be in the context of rates being in the stimulatory zone (at 1.35%).
An outsize print for inflation with rates still in the stimulatory zone will make a further strong case for a third increase of 50 basis points.
The Governor’s Statement following next week’s Board meeting and the associated Minutes which will print on July 19 will provide some guidance as to whether the Board believes the cash rate is still stimulatory at 1.35%.
We think the need to contain those inflationary expectations in the face of another outsize inflation print and the assessment that policy is still stimulatory will indicate to the reader that the Board is open to a third 50 basis point move in August.
We would be very surprised if the Statement indicates a commitment to scale back the rate hikes to that “steady” 25 basis point process for the remainder of the year.
In fact, our view is that a better policy would be to raise the cash rate by 50 basis points in August and then pause in September so that the unprecedented cumulation of four consecutive meetings totalling 175 basis points can be assessed.
There will be no indication of that strategy in July. We will have to await the August Statement to see whether the pause is favoured by the Board.
Conclusion
The 50 basis point increase in the cash rate at the July 5 Board meeting seems highly likely.
We will be particularly interested in any guidance the Governor may provide about the August meeting, where we expect a third consecutive 50 basis point move prior to a pause in September.
The June quarter inflation data, to be published on Wednesday July 27, will be a key update a little less than a week prior to the August Board meeting.
