The RBA hikes again & signals the risk of more to come

The RBA hiked by another 25bp to 4.1% as it worries about high inflation and seeks to assure households and businesses it will return inflation to the 2-3% target.   

1. The RBA raised the cash rate again, up another 25bp to 4.1%.

The RBA hiked rates again, increasing the cash rate by 25bp to 4.1%, with the interest rate on exchange settlement balances increased by 25bp to 4%. 

Plans for passive quantitative tightening were left unchanged, although the RBA recently said that it would review its plans when the Term Funding Facility loans are repaid, such that active QT seems likely later this year. 

The rate hike surprised the market in terms of its timing, as the market had factored in the chance of a hike today, with an increased probability that the RBA would hike in a month or two’s time.

2. The RBA is catching up to where it should have been months ago.

As we have previously pointed out, simple policy rules have long pointed to the risk of higher interest rates given the highest inflation rate since the 1980s and the lowest unemployment rate since the 1970s, where past large disinflations have required interest rates well in excess of the neutral rate and an unemployment well above the NAIRU. 

With the RBA recently increasing its estimate of the neutral nominal cash rate to c3.8%, the RBA seems to be belatedly recognising that it could prove difficult to sustainably return inflation to the 2-3% target band, not only hiking today, but repeating that, “some further tightening of monetary policy may be required to ensure that inflation returns to target in a reasonable timeframe … [depending] upon how the economy and inflation evolve … [with the board continuing] to pay close attention to developments in the global economy, trends in household spending, and the outlook for inflation and the labour market”.

In terms of what pushed the RBA over the line to hike today, the policy press release mentioned:

(1) the aim of the ”further increase in interest rates is to provide greater confidence that inflation will return to target within a reasonable timeframe”, which chimes with Governor Lowe recently testifying that households and businesses were less confident than investors that the RBA would return inflation to its target;
(2) related concern over the large increases in the minimum and other award wages, stating that, “growth in public-sector wages is expected to pick up further and the annual increase in award wages was higher than it was last year”;
(3) a belated recognition of familiar and longstanding risks to inflation: “recent data indicate that the upside risks to the inflation outlook have increased and the board has responded to this … [where] while goods price inflation is slowing, services price inflation is still very high and is proving to be very persistent overseas, [while] unit labour costs are also rising briskly, with productivity growth remaining subdued”; and
(4) “housing prices are rising again”, where the RBA had previously thought that falling prices had signalled that monetary policy was restrictive.

3. Governor Lowe will likely be hawkish when he speaks tomorrow and may have less faith in achieving a “narrow path” to a “soft [economic] landing”.

Governor Lowe is speaking tomorrow at 9:20am at an investment bank conference. 

There is no topic at this point, but the speech will be provided to the media under embargo and there is a Q&A session that will be open to the press. 

In addressing today’s decision, he will likely stress that the RBA will hike as needed to dissuade workers from seeking larger pay rises post the Fair Work Commission’s decision, so as to anchor household and business inflation expectations, as well as repeat his belated concern about strong growth in unit labour costs. 

The strength in unit labour costs reflects higher labour costs and poor productivity, where slower growth in labour costs requires an unemployment rate well above the NAIRU, which Governor Lowe subjectively puts in the low 4s, the RBA staff assumes is 4½%, and the RBA inflation model puts at around 5% (note that today’s press release still characterised the labour market as tight). 

Turning productivity around is very difficult around and typically requires companies to lift the capital stock and/or increased efficiency/technological progress, neither of which can be easily achieved in the short to medium term. 

This leaves the more unpalatable option of companies increasing productivity by either not hiring or letting some staff go, which would add to the upward pressure on unemployment. 

Governor Lowe may be unwilling to publicly discuss the latter option, but it could see him express less confidence that the RBA will be able to achieve its “narrow path” to a “soft [economic] landing”. 

In defending higher interest rates, Lowe should build on the themes of his recent testimony regarding the damaging economic and social costs of high inflation, which were summarised in today’s press release.

Note that Lowe’s speech is before the release of Q1 GDP, where today’s rate hike suggests that the RBA either is not forecasting either a flat/negative outcome, or, if it is does, believes that containing high inflation trumps worrying about output. 

4. The government will soon decide on Governor Lowe’s future.

The treasurer said some weeks back that the government will decide whether to reappoint Governor Lowe around the middle of the year, where his term finishes in September. 

It still seems likely that the government will seek to replace Governor Lowe, assuming they can find a suitable candidate. Former Bank of Canada Senior Deputy Governor Wilkins, who ran the recent review of the RBA, is reportedly not interested in the role, which likely puts Secretary to the Department of Finance Wilkinson and Deputy Governor Bullock at the top of the list of possible replacements.