The RBA on track to hike next week given high inflation

High underlying inflation points to the RBA raising rates next week, with the door open to more hikes given the RBA is weighing up whether the neutral policy rate and NAIRU are higher than it has assumed, while warning of some drift in inflation expectations.

The RBA is likely to raise rates next week as staff raise forecasts for both inflation and unemployment.
The RBA meets on 2-3 November and will likely unanimously vote to raise rates by another 25bp given above-forecast high inflation, upside risks to inflation, and a still-tight labour market. Staff will also update the bank’s economic outlook, where the RBA has already signalled that it will raise its forecast profiles for both unemployment and inflation. Unemployment could peak at 4.9-5.0% (previously 4.8%) and underlying inflation will likely be bumped up by 0.1-0.3pp for the next year and a half, with inflation reaching the 2½% target in 2028 (unchanged).

The RBA board has been too optimistic on the neutral policy rate and the NAIRU.
The RBA will remain hawkish given it is weighing up whether it needs to further raise its assumptions for both the neutral policy rate and the NAIRU, while fretting over inflation expectations. Market pricing suggests that the neutral rate has increased from the average staff estimate of 3½% to around 3¾-4%, while the board continues to be too optimistic in overwriting the average staff calculation of a 5.0% NAIRU with a 4.6% assumption. Inflation expectations are hard to measure, but the RBA is concerned by an upward drift in expectations from the unpublished Macquarie University business survey.

A revised RBA outlook and revised board assumptions could open the door to more rate hikes.
Policy rules based on the RBA’s economic outlook and assumptions have long pointed to a peak in the cash rate of 4¾% in rounded terms, but higher forecast inflation, revised estimates for the neutral policy rate and the NAIRU, and the risk of rising inflation expectations would open the door for more rate hikes.

Falling house prices might help the RBA to control inflation.
In terms of the risks to this outlook, the significant downturn under way in the housing market could act as a substitute for a further tightening of policy. More generally, there is also considerable uncertainty relating to the Iran war, which poses a downside risk to activity and an upside risk to inflation, as well as the eventual end of the AI boom.

Core inflation has picked up.
Underlying inflation – as measured by the trimmed mean CPI – has picked up this year, contrasting with the RBA’s earlier expectation that it would grow at a steady quarterly rate of 0.8% before moderating next year. The trimmed mean CPI increased by 1.0% in Q3 to be 3.7% higher than a year ago, which is the highest annual inflation rate since mid 2024. The equivalent measure based on the full set of monthly prices was higher at 1.1% on a rolling 3-month basis, although we think this is overstated given our earlier analysis pointed to residual seasonality in July (the ABS cannot properly seasonally adjust all the monthly prices in the CPI because some goods and services have too short a history).

Domestic price pressures remain strong.
As for what the RBA regards as domestic inflation, the market sector services CPI has been volatile lately, but rebounded in Q3, up 1.2% after a 0.6% increase in Q2, to be 3.5% higher than a year ago. Growth in unit labour costs – which are the main cost for most businesses – is off its highs, but the strength in services inflation might tie in with the RBA reporting some signs of rising business inflation expectations.

Tech prices are adding to inflation.
Consistent with the US experience, we estimate that tech prices are up 3.7% over the past year, adding about 0.2pp to annual core inflation. This contrasts with falling tech prices in the pre-COVID years, when tech goods subtracted an average 0.3pp from annual core inflation.