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At next week’s Monetary Policy Board meeting, the RBA will decide to keep the cash rate at 4.35%. This is the overwhelming view of professional forecasters (all 25 forecasters on Bloomberg’s panel of experts, including QIC, expect the RBA to keep rates on hold), and the market (which is pricing zero chance of a rate hike next Tuesday). Overhanging the RBA’s decision is the spectre of stagflation. That is, the possibility of rising inflation and a falling level of economic activity - not just falling economic growth, but a negative rate of economic growth. To be clear, the Australian economy is not in stagflation - yet. Nor do we forecast the economy to enter stagflation. But the probability of stagflation, or at least an extended period of sub-trend growth is rising the longer the Strait of Hormuz remains closed and the longer the price of oil remains over US$90/bbl. In fact, the oil price is currently trading at US$90/bbl, its lowest level in almost 12 weeks, as US operations have seen non-Iranian oil leaving the Strait rise by 50% from 1.2 million barrels a day, to 1.8 million over June.
Nonetheless, a price of US$90/bbl remains almost 40% higher than the average price of oil prior to the outbreak of the war. In addition, it is generally accepted that the oil price will take time to return to its pre-war levels given the disruption to supply chains. The prospect of the oil price remaining elevated increases the risk of pass-through of higher costs of inputs directly impacted by higher oil prices (such as fuel, fertilizers and plastics) through the supply chain, creating an inflationary momentum that would undercut economic growth and diminish confidence in the RBA’s ability to control inflation. But with the direction of oil prices still in the balance, the RBA will be reluctant to add pressure to an already weakening economy. Which brings us to the RBA’s key dilemma; how to balance the risk of higher inflation against the risk of weaker growth? Interestingly, this dilemma (how to weigh inflation against economic growth) is not faced by all major central banks. For example, the European Central Bank (ECB) and the Bank of Japan (BoJ) have price stability as their primary objective with growth/full employment a secondary consideration only if consistent with price stability.
The Bank of England (BoE) and the Bank of Canada (BoE) have a conditional dual mandate which prescribes price stability as the primary goal of the Bank, with maintaining growth and full employment as a secondary target. The US Federal Reserve and the RBA are two major banks that have a dual target with a similar weight placed on price stability and growth/employment. How have the major central banks responded to the current environment? Let’s start with the ECB and BoJ, that have price stability as their target. Yesterday, the ECB began a tightening cycle with a 25 basis point rate hike, flagging the prospect of a further hike in July if the Iran war drags on. This is despite euro area economic activity declining in the March quarter, with weak growth also forecast for the June quarter. Similarly, the market is pricing an almost 100% probability of a rate hike at the BoJ’s meeting next week, despite economic growth being expected to slow to just 0.2% in the June quarter. What of the two banks with the conditional dual mandate? The BoC kept rates on hold this week at 2.25%. In his opening statements at the monetary policy decision press conference, BoC Governor Tiff Macklem commented that “Monetary policy continues to be focused on ensuring higher energy prices do not turn into persistent inflation.” But Governor Macklem also acknowledged that “Economic weakness combined with rising inflation is a dilemma for monetary policy.” The BoE also meets next week, with the market and professional forecasters expecting virtually no chance of a rate hike. However, the market is pricing a rate hike by year end, even as the UK economy is forecast to stall over the June and September quarters. This brings us to the world’s most important central bank, the Fed, which also has a policy meeting next week – the first to be chaired by Kevin Warsh. Unlike his colleagues in the other major banks, Chair Warsh and the Fed are faced with strong (rather than weak) economic growth and rising inflation. There would seem little to prevent the Fed from raising rates. Nonetheless, the market is pricing no chance of a Fed hike next week. Of course, we know of the political overlay confronting Chair Warsh and the Fed, which makes the Fed somewhat of an outlier among major central banks.
Where does this leave the RBA? The RBA confronts rising inflation, with the annual rate of both headline and underlying inflation above 3% (the upper bound of the RBA’s target range), and the prospect of further price pressures as higher oil prices feed through the supply chain. But it also faces slowing economic growth, with just 0.3% GDP growth in the March quarter and forecasts of even weaker growth over the June quarter. Layered over the outlook is the impact of recent Federal government tax changes on capital gains, negative gearing and trusts that have increased the risk of a more severe housing downturn and damaged business and investor confidence. In addition, the policy of the Fair Work Commission to preserve the spending power of lower income earners by effectively indexing minimum award wages to inflation risks speeding up the pass-through of higher oil prices to the rest of the economy via higher labour costs. The Australian economy has proved to be resilient in the post-Covid years. The economy’s ability to shift resources across sectors (from mining to housing for example) and our willingness to fill skill shortages with a robust migration program has led to a nimble economy. The ability to seek out new international markets for our exports and to develop new export-oriented industries have also been a hallmark of our past performance as has been our workforce’s willingness to trade higher incomes for productivity gains. Many of these factors that contributed to the Australian economic resilience are being challenged by the current geopolitical landscape.
Unfortunately, the RBA has but one policy lever at its disposal – interest rates. That policy is best leveraged to maintain price stability. The worst of all possible worlds is a sagging economy with runaway inflation. While the RBA can remain on hold next week, it must remain vigilant to inflation and a lift in the cash rate to 4.6% and even 4.85% by year end cannot be ruled out if the Strait of Hormuz remains closed well into the September quarter.
