The RBA’s narrowing path to a soft landing
At its monetary policy meeting on May 3, the Reserve Bank of Australia (RBA) surprised the market by hiking its Overnight Cash Rate (OCR) by 25bps to 3.85% (Fig 1a). Following its decision to pause rate hike last month, investors had expected the RBA to leave rates unchanged for the next several meetings to assess “the state of the economy” and “impact of the increase in interest rates to date”. Justifying its abrupt volte-face, the central bank said “inflation… is still too high and it will be some time yet before it is back in the target range”.
The challenge of achieving a soft landing:
The RBA’s willingness to pause rate hikes in April was predicated on its desire to “keep the economy on an even keel”, allowing inflation to return more gradually to target while retaining the employment gains of the past few years. While, the latest quarterly inflation print “showed a welcome decline in inflation”, with headline CPI slowing to 7.0%y/y and core CPI moderated to 6.6%y/y, the RBA acknowledged these levels (Fig 2a) remain elevated by global standards. Australia’s core CPI is higher than that in the US, EU and UK – with the latter three markets’ central banks all likely to hike further at their upcoming meetings. In addition, before this month’s rate hike, the RBA had only hiked by 350bps, lower than that of the Fed and BOE (who both started earlier), while equal to ECB’s magnitude who started hiking later.
The RBA also admitted that most of the recent slowdown in Australia CPI was due to lower goods price inflation, while “services price inflation is still very high and broadly based”, suggesting future declines in inflation will be slower. With the central bank’s latest forecasts suggest inflation will slow to 4.5% by the end of 2023 and only reach the upper limit of its 2 to 3% range by mid-2025 – it has a very narrow window to achieve its mandate – especially given “the labor market remains very tight, with unemployment rate at a near 50-year low” (Fig 2b).
Ahead of the decision, markets were pricing a fairly low probability of a rate hike, while 21 out of 30 economists surveyed by Bloomberg expected rates to remain unchanged. Following the decision, the AUD jumped sharply higher while bond yields increased significantly across the curve.
The accompanying statement was decidedly hawkish. The central bank stated that “some further tightening of monetary policy may be required to ensure that inflation returns to target in a reasonable timeframe”. Eschewing any references to a pause in rates hikes, the RBA committed “to pay close attention to … the outlook for inflation and labor market”, while confirming it would “remain resolute in its determination to return inflation to target and will do what is necessary to achieve that”.
This suggests the RBA is now more comfortable “for the economy to continue growing, albeit at a below-trend pace”, to help reduce price pressures. In subsequent remarks at the Reserve Bank Board Dinner, Governor Lowe further justified the decision to hike rates by highlighting the significantly more detrimental impact of higher inflation on society relative to higher interest rates. While Governor Lowe confirmed that the RBA “is not on a pre-set path”, his reference to “worryingly persistent services price inflation” does suggest that further rate hikes may be needed.
With the next quarterly inflation print not due until July, investors are now anticipating a further rate hike in August – although the future trend in household spending, the strength of the labor market and the stickiness of core inflation will be key determinants.
For Australian dollar cash investors, the latest rate hike should be welcome news, bringing cash rates to a new decade high. As for investors with a longer investment horizon, the re-steepening of the yield curve will offer additional yield pick-up. Nevertheless, with interest rate volatility likely to remain high, investors should consider pursuing a cautious and diversified approach to cash investing.