Why the RBA's rate hiking plans are due for a slowdown

In justifying another 50 basis point rate hike, the RBA reiterated that inflation is the highest it’s been since the early 1990s and it is set to rise further with strong demand and a tight labour market playing a role. 

Indeed, the labour market remains tight. While wages growth has picked up and in some areas, labour costs are increasing briskly, it is important that medium-term inflation expectations remain, in their words, “well anchored”. 

The RBA’s rapid rate hikes reflect a desire to bring demand back into line with constrained supply and to contain inflation expectations by reinforcing its commitment to its inflation target.

This is the fastest increase in rates since a total increase of 2.75% over five months from August to December 1994. The speed of the rate hikes compared to the last three tightening cycles reflects the extent of the blowout in inflation and the low starting point for the cash rate.

The RBA’s commentary remained hawkish reiterating that it will “do what is necessary” to return inflation to target and it indicated that it expects to raise “interest rates further over the months ahead”.

Banks are likely to pass the RBA’s rate hike on in full to their variable rate customers and deposit rates will rise further. This will take variable mortgage rates to their highest levels since 2012.

This may not have hit spending much yet, but it will in the months ahead. As Milton Friedman long ago observed the lag from a change in monetary policy to its impact on the economy is “long and variable.” 

Given the blowout in inflation, the RBA has been right to act aggressively to slow demand back to be more in line with supply and to signal its commitment to get inflation back to its 2-3% target as this will help keep inflation expectations down. 

The experience of the 1970s and early 1980s highlights the importance of keeping inflation expectations low. 

And the RBA is right to point out that “price stability is a prerequisite for a strong economy and a sustained period of full employment”.

So far the jobs market remains tight and consumer spending remains strong. However, based on the experience in the late 1980s ahead of the early 1990s recession this is not particularly surprising and it's only a matter of time before spending starts to slow. As such, we believe the RBA needs to start treading more carefully.

Money market expectations for a cash rate of around 3.8% are still too hawkish and there is a strong case to slow down the pace of rate hikes

What happens now?

We remain of the view that the cash rate won’t have to go well above 3% before the RBA achieves its aim of cooling demand enough to take pressure off inflation and keep inflation expectations down.

Given the significant monetary policy tightening already seen, the reality is that this will only hit the economy with a lag as it takes a few months for rate hikes to be passed on to borrowers and then for borrowers to adjust their spending. 

In addition, the big hit from falling real wages and the increasing weakness in leading indicators notably consumer confidence and housing, there is a strong case for the RBA to slow the pace of tightening to give more time to assess its impact so far.

Given the lags involved and the slump already evident in leading indicators a failure by the RBA to slow the pace of tightening and to raise the cash rate towards 4% as the money market is assuming would risk recession and overkill in taming inflation.

Fortunately, while the RBA’s guidance on rates remains hawkish it is indicating an awareness of these issues – with its comment that “higher interest rates are yet to be fully felt in mortgage payments” and its awareness of falling confidence and home prices. Along with its desire to “keep the economy on an even keel” and that “it is not on a pre-set path”, it suggests that it may be moving towards some slowing in the pace of hikes in the months ahead. 

However, it's looking like our assessment that the cash rate will peak around 2.6% around year-end is too dovish and so we have revised it to 2.85% (thanks to an extra hike in December). Having said this, we continue to expect rate cuts towards the end of next year though.

We continue to see average home prices falling 15-20% top to bottom and this is occurring earlier and faster than previously expected. A rise in the cash rate towards 4% as the money market is assuming would likely result in steeper falls in home prices. 

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