Why are interest rates still rising in Australia?

While markets have coalesced behind the view that rates will stay higher for longer, the consensus expectation for central banks in major economies such as the Fed, the ECB, the BOE and the BOC is that they are, based on current data, done raising rates.

In the US, inflation has fallen from a peak of 9.1% in June 2022, to 3.2% in October 2023, but it is still above the Fed’s target of 2%. While markets are pricing in rate cuts starting in mid 2024, the US Fed are still talking up the need to avoid complacency and is keen to ensure that falling bond yields - based on the expectation of earlier rate cuts - doesn’t undermine its efforts.

According to Jerome Powell, “If it becomes appropriate to tighten policy further, we will not hesitate to do so. “

Falling price and wage inflation data along with a resilient labour market and economic activity adds credence to the view that a US recession, which would bring forward rate cuts, can be avoided.

Markets expect the Fed and ECB to be the first major central banks to cut rates. The risks of a Eurozone recession are higher than the US. Traders are pricing in a 25bps cut by both the ECB and Fed in June 2024. In the UK, inflation has fallen from 11.1% just over a year ago, to 6.7%, so while more rate hikes are not priced in, it is expected that the BOE will move slower than peers in cutting rates.

Across the globe, goods inflation is falling as Covid induced supply chain challenges ameliorate. Services inflation, driven by wages, is proving to be stickier.

While the trend is broadly similar for Australia, more rate hikes are possible and RBA governor Bullock is striking a hawkish tone.

The RBA has been hiking rates since May 2022 and has raised the cash rate by a total of 4.25 percentage points, from a record low of 0.1% to 4.35%. The RBA's main rationale for hiking rates is to bring inflation back to its target range of between 2% and 3%, which it has been overshooting since late 2021. Inflation in Australia peaked at 7.8%, the highest level since 1990 but has since fallen to 4.9%.

Some of the factors that have contributed to the RBA's hawkish stance are:

• Services inflation is proving sticky: The RBA noted that services inflation, which accounts for about 60% of the consumer price index, has remained elevated at 5.8%, reflecting strong demand and cost pressures in sectors such as housing, health, insurance, and recreation.
• Wage inflation has picked up: The RBA expects wages growth to stabilise at around 4% before declining gradually, as the labour market eases. The unemployment rate in Australia was 3.7% in October 2023, only slightly above the trough a year earlier of 3.4% which was the lowest level in 50 years.
• House prices have rebounded to just shy of their previous record high: Housing market conditions driven by population growth and limited supply have defied the impact of higher interest rates with national home prices up almost 5% for the year ended October 2023.
• High infrastructure spending: Public infrastructure spending has been an important source of support for the Australian economy, especially during the pandemic. Infrastructure spending is required to serve a growing population and the green transition, but many projects are being cut or deferred to avoid contributing to cost pressures.
• Immigration is also adding to the inflationary impulse with estimates showing 500,000 of new migrants into Australia have arrived in the last year.
• The RBA was late to start raising rates compared with peers: The RBA was the last of the major central banks to cut rates to near zero in response to the pandemic, and the last to start raising them. The RBA has raised rates less than its Anglo-Saxon peers and among major central banks is the only one with the potential for further increases currently priced in. By contrast, the US Federal Reserve, the European Central Bank, and the Bank of England, have paused rate hikes – and markets assess the next move will be down – amid signs of slowing growth and rising uncertainty.

The RBA has indicated that it will continue to monitor the data and the evolving risks to determine whether further tightening of monetary policy is required to achieve its inflation target. They are cognisant that there is a lag between when rate moves occur and the flow on economic impact.

While some analysts have suggested that the RBA may have reached the end of its tightening cycle, or may even need to reverse course and cut rates in the near future, if the Australian economy takes a turn for the worse due to the impact of the slowing economic growth, geopolitical risks, or the spillover effects of tighter financial conditions, the majority are expecting the RBA to be on hold or raise rates one more time.

The market is pricing a cut in late 2024. If the Australian economy proves to be more resilient then that expectation may be optimistic.

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