No time to wait for the RBA

A pre-emptive strike against rising inflation expectations

There will, no doubt, be heated debate around the boardroom table when the RBA Monetary Policy Board meets next week to set the cash rate. Market pricing suggests the decision to hike or keep rates on hold is lineball but has shifted this week in favour of a hike. In some sense, the decision should be straightforward. After lifting rates by 25bps to 3.85% at its first meeting of the year in February, the Bank’s projections were for inflation and interest rates to rise further. Little has changed domestically since the February meeting to challenge that view.

The domestic data flow has indeed been solid. Inflation remained elevated in January, both headline (stable at 3.8%) and underlying (up from 3.3% to 3.4%), while the labour market remained tighter than expected with the unemployment rate at 4.1%. Elevated inflation and a tight labour market are consistent with the strength in the economy observed in the December quarter national accounts, which showed annual real GDP growth accelerating to 2.6%. This is well above estimates of the economy’s speed limit that is dictated by the growth in labour, capital and productivity. With demand growing at this pace, it is little wonder inflation lifted so meaningfully in the second half of last year.

The only remaining question for the next RBA rate hike was timing. Most economists, ourselves included, expected the RBA to wait until May, following the release of the March quarter inflation print, to deliver the next rate rise. But international developments have changed our view. 

The war in Iran poses its most immediate economic impact via higher energy prices. This is particularly relevant for Australia, which imports around 90% of its refined fuel. A lift in global oil prices is therefore transmitted quickly into domestic fuel costs. Our analysis suggests local fuel prices are likely to rise by at least 15% in the near term. With automotive fuel accounting for 3.3% of the CPI basket, this alone adds around 0.5 percentage points (ppts) to consumer prices.

There will also be significant second round impacts on prices as costs rise. According to 2022-23 input-output data, fuel accounts for around 2.5% of industry-wide input costs across the Australian economy. For some industries, the share is far higher. Road transport, for example, relies heavily on fuel, which makes up 20% of its input costs. A spike in road transport costs will drive up food prices, one of the largest components of household budgets and which represent 17.4% of the CPI basket. Fuel also constitutes 31% of airline industry costs. Higher aviation fuel prices will push up airfares, affecting costs of both domestic and international travel, which make up another 6.2% of the CPI basket. Beyond the fuel cost, international air travel prices also surged in response to the disruption to Middle East transit hubs that were impacted by the conflict.

Increased costs are more likely to be passed on to consumers given many industries are already operating near full capacity. In aggregate, the 15% rise in fuel prices could create an additional 0.35 ppts lift in consumer prices via second round effects. Combined with the direct impact, this lifts our forecast for headline inflation to around 4.6% by mid-year. The RBA’s internal projections could be even higher, given their higher starting point projection. A forecast beginning with a 5-handle cannot be ruled out.

As well as increasing inflation, the Middle East conflict has the potential to unravel the global economy, as pointed out in last week's Brief. Higher energy prices, disruptions along the global supply chain, and a tightening of financial conditions as bond yields rise and equity prices fall, could cause a downturn in global growth that requires monetary policy easing rather than tightening. The RBA will be sensitive to this possibility and will not respond blindly to the rise in headline inflation emanating from higher oil prices and could choose to take a wait-and-see approach to monetary policy decisions while uncertainty remains around the conflict and the global economy.

However, as also pointed out in last week’s Brief, inflation expectations will be the key to anticipating central bank responses. A rise in inflation expectations that goes unchecked, risks feeding more permanently through the supply chain via price and wage setting behaviour. Such a situation would require an even more aggressive RBA tightening cycle to bring inflation back under control, even in the face of sharply slowing economic growth. 

Inflation expectations in consumer surveys are already rising. At the same time, the peak in inflation will likely coincide with the Fair Work Commission’s minimum wage decision, increasing the risk that higher inflation becomes entrenched in wage-setting behaviour. However, financial market-based measures of inflation expectations remain well-anchored and in line with the RBA target, having nudged only marginally higher since the conflict began.

For the RBA Board, inflation risks will be front of mind next week. Members will be loath to give away hard earned inflation-fighting credibility gains. But they will have to balance that against the risk of a more serious global economic downturn should the conflict in the Middle East escalate further. 

Given the building inflation threat, the path of least regret for the RBA is to act pre-emptively to reduce the risk of rising inflation expectations. This means delivering a 25bp rate rise next week rather than waiting until May. In choosing that path, the RBA Board would be hoping that early action should spare our economy from more painful adjustments later.