RBA Board Hikes the Cash Rate by 0.25%

Choosing to raise is the better policy option, even if it is not consistent with our interpretation of the implicit guidelines.

The Reserve Bank Board raised the policy rate by another 0.25% at its May meeting, bringing the policy rate to 3.85%.

The decision came as a great surprise to markets, which had priced in less than five basis points. In this tightening cycle, there have been a number of decisions that came as a surprise to markets – the decision to raise the rate by 50 basis points (instead of 25) in June and 25 basis points (instead of 50 basis points) in October

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

In our bulletin last Friday, we stated. “We have argued over the past six months that the peak of the current cycle will be the May Board meeting. We believe the peak should be 3.85%, with the final 25 basis point increase in May based on the current situation – record low unemployment and very high inflation – rather than relying on forecasts. We continue to believe that this would be the better policy approach given the risks, but it does not seem consistent with the Board’s intentions.”

Our assessment of the Board’s intentions relied heavily on the references in the Governor’s recent speech to the importance of ensuring that the inflation path is consistent with the Bank’s forecasts. The Inflation Report for the March quarter indicates that inflation is consistent with (if not somewhat better than) this trajectory.

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.