RBA Review: 25bp Hike to Follow in February, Risk of 15bp or Pause

Summary

• The RBA hiked by 25bps as expected, with the Board comfortable with a slow return of inflation to target. The statement nevertheless noted that the labour market ‘remains very tight’.
• Wage growth is no longer ‘lower than many other advanced economies’ according to the RBA while the cash rate will be raised further ‘but is not on a pre-set course.’
• After today’s 25bps hike to 3.10% we expect another 25bp hike to 3.35% at the February 2023 meeting. However, we note that the risk of a 15bp hike, or pause, has increased.

Details of the Decision

The RBA hiked the cash rate by 25bp to 3.10%, as we expected. This was the third ‘business as usual’ size and takes the RBA hikes to 3pp since May. The decision came without updated forecasts, leaving the wording of the statement key to the rates outlook. Here are the main updates.

Inflation to Return to Target (Slowly)

‘Inflation in Australia is too high’ unsurprisingly remained in the statement. Inflation is expected to peak ‘around 8%’. Unlike other central banks, the RBA is comfortable forecasting a slow return to target [3% over 2024]. Our inflation index shows inflationary pressures are easing (Chart 1).

Positive Data Points in a Very Tight Labour Market

‘The labour market remains very tight, with many firms having difficulty hiring workers’. However, elevated job vacancies and ads ‘have declined a little recently’. They place the slowdown in employment growth as an absorption of spare capacity. Our unemployment index shows a pickup in the unemployment rate is forthcoming (Chart 2). This is, in part, due to a return to migrant workers and a peak in cyclical employment factors.

Wage Growth No Longer Subdued

‘Wages growth is continuing to pick up from the low rates of recent years’. In Q3, it crept above 3% for the first time since Q1-2013. Going forward, the RBA forecasts wages to increase by 3.7% YoY in H1 2023 before peaking at 3.9% in H2 2023. As such, they have removed ‘although it remains lower than in many other advanced economies’. Our Australian wage growth index suggests peak inflationary pressures may be behind us, though more evidence is needed to confirm this (Chart 3).

The Monetary Policy Lag and Outlook

The final paragraph again notes ‘the Board expects to increase interest rates further over the period ahead’ but has importantly added ‘but it is not on a pre-set course’. They are likely thinking ever more about the lag between monetary policy and the effect it has on household spending and mortgages. By March 2023, 70% of hikes will have passed through to mortgage payments. Moreover, most of the fixed rate loans will begin to expire between March 2023 and September 2023.

Bottom Line

For now, we continue to expect a 25bp hike at the 7 February 2023 meeting. However, the probability of a 15bp hike, or even a pause, has increased. The RBA will be influenced by a larger than usual amount of data and updated forecasts at the meeting.

Changes to the Statement

We highlight the changes between the most recent and previous statements. Text with a strikethrough has been removed. Underlined text is an addition.

At its meeting today, the Board decided to increase the cash rate target by 25 basis points to 2.85 3.10 per cent. It also increased the interest rate on Exchange Settlement balances by 25 basis points to 2.75 3.00 per cent.

As is the case in most countries, iInflation in Australia is too high, at 6.9 per cent over the year to October. Over the year to September, the CPI inflation rate was 7.3 per cent, the highest it has been in more than three decades. Global factors explain much of this high inflation, but strong domestic demand relative to the ability of the economy to meet that demand is also playing a role. Returning inflation to target requires a more sustainable balance between demand and supply.

A further increase in inflation is expected over the months ahead, with inflation now forecast to peak at around 8 per cent later this yearover the year to the December quarter. Inflation is then expected to decline next year due to the ongoing resolution of global supply-side problems, recent declines in some commodity prices and slower growth in demand. Medium-term inflation expectations remain well anchored, and it is important that this remains the case. The Bank’s central forecast is for CPI inflation to decline over the next couple of years to be be around 4¾ per cent over 2023 and a little above 3 per cent over 2024.

The Australian economy is continuing to grow solidly and national income is being boosted by a record level of the terms of trade. Economic growth is expected to moderate over the year ahead as the global economy slows, the bounce-back in spending on services runs its course, and growth in household consumption slows due to tighter financial conditions. The Bank’s central forecast for GDP growth has been revised down a little, with growth of around 3 per cent expected this year and 1½ per cent in 2023 and 2024.

The labour market remains very tight, with many firms having difficulty hiring workers. The unemployment rate declined to 3.4 per cent in October, the lowest rate since 1974was steady at 3.5 per cent in September, around the lowest rate in almost 50 years. Job vacancies and job ads are both at very high levels, although they have declined a little recently. eEmployment growth has also slowed over recent months as spare capacity in the labour market has been is absorbed. Wages growth is continuing to pick up from the low rates of recent years, although it remains lower than in many other advanced economies and a further pick-up is expected due to the tight labour market and higher inflation. Given the importance of avoiding a prices-wages spiral, the Board will continue to pay close attention to both the evolution of labour costs and the price-setting behaviour of firms in the period ahead.

The central forecast is for the unemployment rate to remain around its current level over the months ahead, but to increase gradually to a little above 4 per cent in 2024 as economic growth slows.

One source of uncertainty is the outlook for the global economy, which has deteriorated over recent months. Another is how household spending in Australia responds to the tighter financial conditions. The Board recognises that monetary policy operates with a lag and that the full effect of the increase in interest rates is yet to be felt in mortgage payments. Higher interest rates and higher inflation are putting pressure on the budgets of many households. Consumer confidence has also fallen and housing prices have been declining following the earlier large increases. Working in the other direction, people are finding jobs, gaining more hours of work and receiving higher wages. Many households have also built up large financial buffers and the saving rate remains higher than it was before the pandemic.

There has been a substantial cumulative increase in interest rates The Board has increased interest rates materially since May. This has been necessary to ensure that the current period of high inflation is only temporary. High inflation damages our economy and makes life more difficult for people. The Board’s priority is to re-establish low inflation and return inflation to the 2-3 per cent range over time.

The Board recognises that monetary policy operates with a lag and that the full effect of the increase in interest rates is yet to be felt in mortgage payments. Household spending is expected to slow over the period ahead although the timing and extent of this slowdown is uncertain. Another source of uncertainty is the outlook for the global economy, which has deteriorated. The Board is seeking to keep the economy on an even keel as it returns inflation to target, but these uncertainties mean that there are a range of potential scenarios. The path to achieving the needed decline in inflation and achieving a soft landing for the economy remains a narrow one.

establish a more sustainable balance of demand and supply in the Australian economy to help return inflation to target.

The Board expects to increase interest rates further over the period ahead, but it is not on a pre-set course. It is closely monitoring the global economy, household spending and wage and price-setting behaviour. The size and timing of future interest rate increases will continue to be determined by the incoming data and the Board’s assessment of the outlook for inflation and the labour market. The Board remains resolute in its determination to return inflation to target and will do what is necessary to achieve that.

Ben Ford is a Researcher at Macro Hive. Ben studied BSc Financial Mathematics at Cardiff University and MSc Finance at Cass Business School, his dissertations were on the tails of GARCH volatility models, and foreign exchange investment strategies during crises, respectively.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)