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Under the direction of new RBA Governor Michele Bullock, the RBA Board opted to keep the cash rate unchanged at 4.1% for a 4th consecutive month at its meeting this week. The RBA retained its tightening bias, citing the need for more time to "assess the impact of the increase in interest rates to date and the economic outlook". In what was likely a deliberate strategy designed to signal stability and continuity despite the change in leadership, the post-meeting statement was almost identical to the previous month. The October RBA statement flagged two new developments: (1) the upward revision to GDP growth in the first half of the year, and (2) the noticeable increase in fuel prices of late. Could these factors increase the risk of the RBA acting on its tightening bias?
In terms of the upward revision to GDP growth in the first half of the year, the latest National Accounts data were released the day after the September RBA board meeting. The data showed the economy grew by an annualised rate of 1.6% in H1’23, a rate that is below trend but hardly recessionary. Prior to the release of the revised data, and incorporating published RBA forecasts for Q2’23, suggests the RBA had factored in growth of half this pace, an annualised rate of just 0.8%, over the first half of 2023. Surely the economic strength would put upward pressure on cash rates?
While the stronger economy in H1’23 can help us better understand the strength of employment data so far this year, the source of the strength matters for the outlook. And here, we note that the unexpected strength came from factors that are unlikely to be repeated. Further, they are likely to put downward pressure on growth in the second half the year. For example, there was strong growth in plant and equipment investment in the first half of the year of around 5% per quarter. But some of that was investment brought forward from later in the year to take advantage of tax breaks that ended on June 30. In addition, around ¾ of the growth in the economy over the last year has been due to a recovery in services exports, such as tourism and education, which were particularly hard hit during Covid. Most of the easy gains have now been made, and services exports will provide more modest support to the economy over the year ahead. With households still suffering the triple-whammy hit to real incomes from higher interest payments, rising tax payments from bracket creep and high inflation, the second half of this year is likely to be weaker than the first.
The noticeable increase in fuel prices of late, as referred to in the October statement, was clearly on display in the release of the August monthly CPI last week. The monthly CPI inflation rate ticked up from 4.9% in July to 5.2% in August, largely due to a 9% increase in fuel costs. With oil prices continuing to rise over the month of September and the Australian dollar under downward pressure against the US dollar, fuel prices will contribute to further gains in the monthly CPI in September.
Despite this, the all-important quarterly CPI release, which for Q3 is due later this month, is likely to show a further moderation in the annual rate of inflation, driven by slowing inflation in food, housing construction costs and furnishings. This will more than offset rising inflationary pressures in transport, rents and insurance services. Headline inflation is forecast to fall from 6.0% in the June quarter to 5.3% in the September quarter, and to just over 4% in the December quarter. Below trend growth and rising unemployment mean inflation will continue to trend lower over 2024 but is unlikely to move within the 2-3% target band until 2025.
So given these developments, where should the cash rate go from here?
The short answer is “nowhere”. Higher rates are doing their job to slow household spending and there’s still a bit more to be passed through the system. As the one-off factors that supported the economy in H1’23 abate or reverse, the second half of this year is likely to see growth take another leg down to an annualised rate of below 1%. And the risk of a decline in output cannot be ruled out. Inflation is likely to continue to moderate, though at a snail’s pace. We expect the cash rate to be on hold at 4.1% for an extended period from here.
The RBA is forecasting inflation to move back within the target band by late 2025 - in 2 years’ time. That’s a long time for inflation to be above the target band without raising rates further. But the RBA clearly wants to hold on to as many of the employment gains they can and avoid over-tightening. And to date, they look like they’ve had success in navigating this Goldilocks-style slowdown – one that is not too cold that we drop into recession, and not too warm that we risk entrenched inflation. Two risks stand out with this.
The first is that the RBA’s timeframe for allowing inflation to remain above target may be too long – and could see inflation expectations drift higher. Currently, there’s not much evidence of this in financial markets, and we are yet to see hard evidence of it in wage setting behaviour.
The second risk is new information that pushes up the RBA’s inflation forecasts. The RBA would be unwilling to push out their forecast return of inflation to target any further than it already is. And here, a weak Australian dollar could become pivotal. If the higher for longer narrative continues to keep US interest rates elevated, resulting in further downward pressure on the $A, the RBA may be forced to hike again. What would be enough to push them into another rate hike? Certainly, anything below $US0.60 would force the RBA’s hand; around current levels is likely a grey area.