At its first monetary policy meeting of 2023, the Reserve Bank of Australia (RBA) raised its Overnight Cash Rate (OCR) by 25bps to 3.35% (Fig 1a). The move was widely anticipated and represents the ninth consecutive hike in the current cycle.  However, the accompanying statement was more hawkish than expected, with the RBA suggesting “that further increases in interest rates will be needed over the months ahead to ensure that inflation return to target”.

Inflation indicators remain elevated:

Fourth quarter headline inflation surprised to the upside, hitting a three-decade high of 7.8%y/y (Fig 2a), due to a combination of global factors and robust domestic demand.  While the RBA does expect inflation to decline, they anticipate the pace of moderation will be slow, only reaching “around 3% by mid-2025” as services inflation is likely to remain sticky.

Concurrently, the RBA believes that economic growth will slow towards 1.5% in 2023 and 2024, as spending on services decelerates and “tighter financial conditions” - due to the rapid 325bps of rate hikes - “will constrain spending more broadly”.  This is already evident in weaker December retail sales and the rapidly cooling property market where house prices, home loans and transaction volumes have already declined sharply from early 2022 highs.

Notably, the RBA highlighted that the labor market “remains very tight” with the unemployment rate close to 50-year low of 3.5% (Fig 2b).  While the central bank forecasts unemployment rate will increase marginally to 3.75% by the end of 2023, with many firms still experiencing hiring challenges, higher wages pressure is likely to remain a risk. 

Market impact:

The RBA’s hawkish stance surprised markets with bond yields trending higher (Fig 1b) and the AUD becoming stronger following the announcement.  Investors are now pricing in at least two more hikes before any potential pause. 

Outlook:

While the RBA noted that “monetary policy operates with a lag and that the full effect of the cumulative increase in interest rates is yet to be felt”, their recognition that CPI remains too high and their “resolute” determination to return inflation to target struck a hawkish tone.

For AUD cash investors, the latest rate hike and confirmation that more rate increases are likely positive news.  Given the uncertainty over the future direction of inflation and growth, interest rates are likely to remain volatile – suggesting a cautious approach to cash investment is warranted.  Money market and ultra-short duration strategies could continue to present attractive current income opportunities, while proving shelter from still volatile longer duration strategies.

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