The RBA’s decision last week to hike the cash rate by 50bps to 0.85% changes our earlier view that the RBA would be comparatively relaxed about Australia’s inflation outbreak and lift the cash rate gradually to a normal or neutral setting over the next two years. Based on the reasons the RBA gave for the June rate hike, a faster normalisation of the cash rate seems likely. We now see the RBA lifting the cash rate to around 2.10% by the end of this year and a peak cash rate for this cycle around 2.60% in early-2023.
The RBA’s June rate decision was driven essentially by recognition that the forces driving high inflation, strong domestic demand stretching constrained supply, are showing little sign of relenting. Australian companies are becoming more comfortable passing on higher costs to selling prices. Inflation is becoming a broader problem than higher commodity prices. Also, previously modest wage growth is showing signs of lifting and possibly more quickly than previously considered likely.
Essentially, the RBA with its June rate hike has joined the club of central banks that admit they have underestimated the inflation surge and are now being forced to play policy catch-up. The RBA still has less of an inflation problem to deal with than the US Federal Reserve or the Bank of England, but that relative benefit rather than showing in a more gradual tightening pattern of RBA rate hikes should show in a lower terminal cash rate in the current policy tightening cycle for the RBA compared with the US Fed or the Bank of England.
The US Fed is likely to hike the Fed Funds rate by at least 50bps this week to 1.50% or more after evidence in the May CPI report released last week (annual CPI rise 8.6% y-o-y, from 8.3% in April) that US inflation still has not peaked.
The Fed will need to see evidence that annual inflation has started to slide – at least two consecutive monthly CPI readings showing falling annual inflation – before it can consider pausing rate hikes at its six-weekly policy meetings. That may occur late in 2022/early in 2023, but that still means that the two policy meetings at least beyond the one this week will deliver rate hikes and probably at least 50bps each time.
While the US economy is still exhibiting signs of strength in household and business spending and particularly the labour market, that strength will be sapped by relentless Fed policy tightening. It is possible and increasingly likely that the US economy will slip into recession probably next year. Indeed, almost all Fed policy tightening cycles over the past half century where the Fed has delivered a succession of rate hikes over several policy meetings have resulted in recession.
Returning to the RBA’s policy tightening cycle, the aim is a little different to that of the Fed at this stage. The Fed needs to soften US demand to the point where tightness in the US labour market is reduced and the US unemployment rate rises. Rising unemployment in turn softens 5%+ annual wage growth increasing the chance that base-effect reduction in US annual inflation late this year becomes a more sustainable reduction in inflation next year.
The RBA faces different circumstances to the Fed. The Australian labour market is tight, but it has not overheated US-style to the point of driving excessive wage growth. Even though wage growth is on the brink of lifting faster the RBA does not need to generate a rise in the unemployment rate to contain a wage-push element to inflation. Stabilisation around the current Australian unemployment rate will do. In effect, the RBA needs to moderate economic growth, not take a risk killing it to cure entrenched high inflation.
Australia’s economic growth rate has considerable momentum. In Q1, GDP rose 0.8% q-o-q, one of the strongest growth rates in the world. Domestic spending growth was even stronger, up 1.5% q-o-q, underpinned by household and government consumption spending, up respectively 1.5% q-o-q and 2.7% q-o-q. Consumption spending still appears to be rising strongly early in Q2 based on retail spending data.
One part of the Australian economy that is starting to soften is housing activity. House prices have started to fall. The value of new home loans has started to fall, albeit from a very high peak. Housing is highly sensitive to rising borrowing interest rates and the pattern of RBA cash rate hikes now in prospect adding another 125bps at least on top of the latest 50bps to variable mortgage interest rates by Christmas imply housing activity directly detracting from GDP growth through the second half of 2022 and indirectly contributing to softer growth in household consumption spending, the mainstay of strong GDP growth in Q4 2021 and Q1 2022.
Softening GDP growth through the second half of 2022 should start to moderate demand for labour. A stabilising unemployment rate plus base-effect reduction in Australia’s annual inflation rate starting in Q4 2022 allows the RBA to complete its policy tightening cycle in the first half of 2023.
After the RBA’s June policy meeting, we are penciling in another 50bps rate hike in July followed by a brief pause in August and September and then three 25bps rate hikes in October, November and December taking the cash rate to 2.10% by year-end. We see the RBA completing its rate-hiking task with two final 25bps rate hikes in Q1 2023.