US interest rate cuts are imminent and markets are betting the RBA will follow within months

The Reserve Bank’s tough talk on inflation and interest rates is increasingly at odds with that of its central bank peers, including the US Federal Reserve.

RBA governor Michele Bullock this month said it was premature to be thinking about interest rate cuts. Picture: Martin Ollman

The Reserve Bank’s tough talk on inflation and interest rates is increasingly at odds with that of its central bank peers, including the Federal Reserve.

But while the RBA has convinced most economists that it won’t cut rates until February at the earliest, the money market continues to bet the RBA will cut rates at least once by year’s end and deliver almost 1 percentage point of cuts in the cash rate target over the next 12 months.

In the US, Fed chair Jerome Powell’s speech at Jackson Hole last week showed that rate cuts are imminent and the Fed is prepared to do “everything” it can to support a strong labour market.

“The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook and the balance of risks,” he said.

While the US economy continues to grow at a “solid pace” and inflation remains above the 2 per cent target, inflation risks have “diminished” and employment risks have “increased”.

In contrast, RBA Michele Bullock governor said early this month “it is premature to be thinking about rate cuts” in Australia and cuts were “not on the agenda in the near term”.

Market pricing of rate cuts by the end of the year and the following six months “doesn’t align” with the thinking of the monetary policy board, Bullock added.

“The recent slow pace of disinflation is consistent with the assessment that the labour market remains tight and aggregate demand continues to exceed supply,” the RBA said this month.

Of course there are differences, but the basic arguments about “direction of travel” and the “risks” for employment and inflation could be made in Australia. The nation’s unemployment rate has risen from 3.5 per cent to 4.2 per cent, similar to the increase from 3.4 per cent to 4.3 per cent in the US.

Australia’s headline inflation rate has dropped from 7.8 per cent to 3.8 per cent while in the US it has fallen from 9.1 per cent to 2.9 per cent. US disinflation has resumed after stalling for a few quarters and the RBA continues to forecast that Australia’s inflation rate will slowly fall back to the target.

Both have a substantial amount of fiscal stimulus and immigration supporting economic growth, but Australia’s economic growth rate is a bit over 1 per cent whereas US growth is about 2 per cent.

Like the Fed, the RBA will probably cut rates before inflation actually hits the target but it’s unclear what that point will be. Also, as recently highlighted by the Reserve Bank of New Zealand’s pivot to cuts in recent months, central banks can and do change their minds quite rapidly.

Gareth Aird.

By the time of the RBA’s March 1, 2022 meeting, Australia’s inflation rate had accelerated to 4 per cent annualised in the December quarter.

However, the RBA didn’t think it was sustainable.

“The board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range,” then governor Philip Lowe said at the time. “While inflation has picked up, it is too early to conclude that it is sustainably within the target range.”

The RBA was “prepared to be patient” as it monitored the inflation outlook.

Two weeks later the Fed cut rates. Still, at its April meeting, the RBA worried that “growth in labour costs has been below rates that are likely to be consistent with inflation being sustainably at target.” One month later, the RBA cut rates, first by 25 basis points, then by 50 basis points for four consecutive months. To be sure, these were highly unusual times after the pandemic.

However, the money market is again betting that the RBA’s view about the interest rate outlook will be incorrect, albeit not to the same degree that it was about its previous forward guidance that the conditions for rate hikes wouldn’t be met “until 2024 at the earliest”.

The Fed focuses more on core PCE inflation, but by way of comparison, six-month annualised core US CPI inflation – a gauge of inflation “momentum” – is 3.2 per cent versus 3.6 per cent in Australia. If Australia’s underlying inflation rate were to fall from 0.8 per cent to 0.7 per cent for the June quarter, the six-month annualised rate would fall to 3 per cent, the top of the target band.

Perhaps that would be enough disinflationary progress for the board to consider a rate cut in the context of a weakening labour market, particularly if other central banks are cutting and the Aussie dollar is rising.

CBA wonders why the RBA has reintroduced forward guidance on interest rates in recent weeks. The RBA’s 2022 review of such guidance said: “In most situations, the preferred approach is to leave the markets and public to draw their own inference about the timing and extent of future interest rate movements using information provided by the Bank and other information more broadly.”

Early last month, markets were aggressively pricing in rate cuts amid market turmoil and the RBA board may have wanted to project calm. But in subsequent parliamentary testimony, the governor doubled down on her guidance that rate cuts were unlikely before year end.

Minutes of the RBA’s August meeting said it was “unlikely that the cash rate target would be reduced in the short term”. However, they also kept their options open by saying it was “not possible to either rule in or rule out future changes in the cash rate target”.

CBA is the only big four bank expecting the RBA to cut rates this year.

“Notwithstanding, it is clear in our view that the RBA has introduced forward guidance since the August board meeting, but it is not clear to us why,” said CBA head of Australian economics Gareth Aird. “Being highly data-dependent sits at odds with forward guidance. Perhaps more significantly, using forward guidance is inconsistent with the RBA’s 2022 review into forward guidance.”