The first RBA rate hike when it comes is likely to shock the household sector according to RBA Governor Lowe mostly because there has not been a rate hike for seven years. This shock factor combined with other reasons may help the RBA plan the next rate hiking cycle to limit the extent of how far the cash rate needs to rise. Rate hikes in the approaching cycle may well have more impact than similar-sized rate hikes in the past implying a need to hike less.
One reason why the RBA will need to hike rates by less than it has in the past is that the “neutral” setting for the cash rate appears to be lower than it has been in the past. The “neutral” cash rate is the rate that neither actively primes economic growth or nor reduces economic growth and promotes low and stable inflation. Over the past two decades the “neutral” cash rate seems to have fallen from around 4.50% to around 3.50% or less.
The current 1.50% cash rate set in mid-2016 sits well below the “neutral” rate and continues to stimulate economic growth and over time higher inflation too. At present, the RBA can afford to allow the stimulatory cash rate to stay in place a little longer. While economic growth is erratically picking up pace it has not yet lifted above long-term trend growth and while more labour and investment resources are being used generating growth there is still some excess capacity to be utilized before the prices of resources are bid upwards generating inflationary pressure.
Wages growth has become an important indicator for the RBA of when the first signs are starting to show of capacity strain potentially generating higher inflation. Wages growth is showing the first signs of lifting although the increases so far have been modest. One issue is how long can the RBA afford to leave a very growth stimulatory cash rate setting in place when the first signs of a lift in wages start to show? If the RBA wants to limit the extent that it needs to hike rates, a reasonable objective to limit the likelihood that a heavily indebted household sector does not make spending decisions capable of causing a recession, it should not delay hiking the cash rate too long.
Monetary policy change, even one that provides a shock, still impacts the economy with a delay of several months. The RBA is unlikely to want to find itself in a position where either before its first cash rate hike, or just after, it is confronted by data showing a more marked acceleration in wages growth and or inflation. The risk is increasing that either the Q2 CPI and wage readings (due late April/mid-May) or the Q3 CPI and wage readings (due late July/ mid-August) show more pronounced acceleration.
If the RBA wants to limit the scale of cash rate hikes and ensure that less rate hikes are effectively more, it needs to start hiking before it becomes too clear that wages growth and inflation are increasing. Our view remains that a cash rate hike in August or September followed by a second cash rate hike in November should fit the bill. Two rate hikes later this year, helped by the “shock” factor mentioned by RBA Governor Lowe should also mean that the RBA can aim to lift the cash rate in 2019 perhaps to the low-side of what is widely considered the “neutral” cash rate – say perhaps a terminal cash rate of 3.00% early in 2020.
Alternatively, if the RBA chooses to wait for hard evidence of rising wages and inflation, say until early 2019 before starting to hike, the shock factor of the first cash rate hike will probably be less and there is a risk that the RBA could find itself chasing escalating wage and inflation reports with cash rate hikes. Inevitably, the RBA would need to deliver more cash rate hikes and might ultimately need a cash rate moving to the high side of what is deemed to be neutral – a terminal cash rate nearer to 4.00%. This higher terminal cash rate would increase the risk of adverse spending decisions by the household sector collapsing the economy in to recession.
Whatever course the RBA chooses to take with monetary policy the peak cash rate is likely to be less than it has been in the past – closer to 3.00% if the RBA acts sooner as opposed to nearer 4.00% if it chooses to delay hiking until 2019. Our view is that the RBA will want to make the most of less is more monetary policy tightening. The first cash rate hike is probably no more than four months away and that is good news reducing the risk that the economy slips in to recession in later in 2019 or in 2020..