Reserve Bank of Australia – Pausing on optimistic forecasts
At its monetary policy meeting on 1 August 2023, the Reserve Bank of Australia (RBA) decided to leave the Overnight Cash Rate (OCR) unchanged (Fig 1) for a second month. This follows a cumulative 400bps of rate hikes over the previous fifteen months, which has taken base rates to a decade high of 4.10%. Explaining its decision, the RBA noted that “higher interest rates are working to establish a more sustainable balance… in the economy”, while “uncertainty surrounding the economic outlook” remains. The central bank also observed the recent decline in price pressures and updated economic forecasts that suggest inflation will return to target within a reasonable timeframe.
A wider path to a soft landing
The second quarter inflation data was helpful news for the central bank – suggesting a wider path to their desired soft landing. The headline rate printed lower than expected, increasing by 0.8%q/q, slowing the annual pace to 6.0% from 7.0% previously. Core inflation also eased to 5.9%y/y, aided by lower food, housing and transportation costs. The latest RBA forecasts predict CPI will decline to 3.25% by the end of 2024 and “be back within the 2-3% target range in late 2025”. Concurrently, the impact of previous rate hikes is now visible in economic growth with household consumption slowing, manufacturing softening and construction moderating. The RBA suggests this “period of below trend growth is expected to continue for a while”, with the central bank predicting GDP will slow to 1.75% in 2024 before recovering slightly to 2.00% in 2025. Over time, this should reduce consumer demand, lessen labor shortages (employment is forecasted to increase to 4.5% by the end of 2024) and curtail wage growth – especially, as the RBA believes “medium term inflation expectations have been consistent with the inflation target”.
Nevertheless, the economy still faces multiple upside inflation risks that could upset the RBA’s optimistic narrative. The absolute level of core inflation remains elevated relative to the central bank’s 2-3% target range. Services inflation has proved persistently sticky, reducing the possibility of further sharp declines in core inflation, with the RBA observing “the prices of many services are rising briskly” while “rent inflation is also elevated”. Meanwhile, the unemployment rate has declined back towards 50-year lows with labor shortages and higher living costs encouraging faster wages growth. Finally, growing consumer expectations that interest rates are near a peak has encouraged a recovery in the property market – with house prices rising for the past five months from their February 2023 low.
Following recent, less hawkish, RBA comments and the better-than-expected Q2-23 inflation data, markets had reduced the probability of an August rate hike from over 50% to less than 20%; although interestingly 18 out of 30 economists polled by Bloomberg still predicted a rate hike. Following the RBA’s announcement, market movements were relatively muted with the AUD declining slightly while bond yield dropped modestly across the curve. Market pricing of additional rate hikes has also fallen, with 26% probability of one additional hike by November to a peak rate of 4.26%.
Keen to achieve a soft landing, the RBA leveraged the better than expected second quarter inflation data as justification to hold interest rates steady, while providing “further time to assess the impact of the increase in interest rates to date and the economic outlook”. Its latest economic forecasts also painted an optimistic picture of moderating economic growth allowing inflation to return to target. However, acknowledging the upside risks to inflation, the RBA was keen to affirm its commitment to “ensuring inflation returns to target” and noted that “some further tightening of monetary policy may be required”.
For AUD cash investors, the current high rates of return on short term investments and upward sloping yield curve continue to present relatively attractive investment opportunities. While the RBA confirmed it will remain data dependent, we believe that robust employment data and elevated inflation imply at least one further rate hike is likely. This suggests investors could consider pursing a cautious and diversified approach to cash investing.
Diversification does not guarantee investment returns and does not eliminate the risk of loss.
This information is generic in nature provided to illustrate macro trends based on current market conditions that are subject to change from time to time. This generic information does not take into account any investor’s specific circumstances or objectives and should not be construed as offer, research or investment advice.