Inflation blowout raises interest rates risk

The Reserve Bank must decide whether to risk causing a recession to bring inflation down, or a prices-wages spiral that requires even higher interest rates in future.

It’s crunch time for the Reserve Bank as it must decide whether to risk causing a recession to bring inflation down, or a prices-wages spiral that requires even higher levels of interest rates in future.

Interest rate expectations jumped after CPI data showed higher-than-expected headline inflation of 7.8 per cent on-year, and trimmed mean CPI – the RBA’s preferred gauge of underlying inflation – hit a 32-year high of 6.9 per cent, well above a 6.5 per cent rise expected by the RBA and economists.

The sharemarket was surprisingly resilient, with the S&P/ASX 200 falling just 0.3 per cent to 7468.3 points after hitting a fresh nine-month high of 7507.3. But the Aussie dollar rose amid expectations of higher interest rates, climbing 1 per cent to a five-month high of US71.07c. The 10-year bond yield jumped 15 basis points to 3.52 per cent. The 3-year yield rose 22 basis points to 3.12 per cent.

The market-implied chance of another 25 basis point rate hike in February rose to 92 per cent from 52 per cent, and the terminal rate implied by the market rose to 3.8 per cent from 3.6 per cent.

GSFM advisor Steve Miller – a former head of fixed-income at BlackRock – says the CPI data now represent some “seriously awkward optics for the RBA”.

The RBA’s “comparative caution” in raising its policy rate from a record low of 0.1 per cent in May to a decade high of 3.1 per cent, was “at best premature and at worse egregiously misplaced.” US inflation was higher, leading the Fed to hike by 425 basis points last year.

“It is not clear that the RBA has learnt the lessons of both recent post-pandemic history and lessons of decades past — the high and persistent global inflation of the 1970s,” Miller says.

In Australia, high inflation wasn’t finally wrung out of the system until the RBA hiked the cash rate all the way to 18 per cent, sparking the early ‘90s “recession we had to have”.

Changes to the wage-setting framework, like pattern bargaining and CPI based increases in minimum and award wages, run the risk of entrenching higher inflation in Australia compared to elsewhere.

The RBA defended its comparative caution last year by warning on “scorching the earth” to get inflation down, implying a more aggressive approach would involve outsized costs in terms of activity and employment. But in the ‘70s, economic “scorched earth” came as central banks exhibited excessive caution in containing inflation, forcing them to eventually go much higher.

Miller says the lesson from that period, in terms of potential dislocations in growth and jobs, is that the least costly path in containing inflation, is to be aggressive early on in the piece.

In his view the RBA’s “underappreciation of the persistence, magnitude, and momentum in inflation” which led it to its infamous guidance to borrowers in late 2021 that it “is not expecting to increase the cash rate for at least three years”, continues to drive an overly cautious approach on rates.

After the unprecedented levels of stimulus delivered during the pandemic, he feels the rate hikes and quantitative tightening through 2022 were a “return to some version of normality”.

Perhaps significantly tighter conditions are needed to curb inflation, including in Australia.

Miller says some of the RBA caution reflects a belief in “Australian exceptionalism” — the notion that Australia’s wage and inflation circumstances are somehow less challenging than elsewhere in the developed country complex.

But evidence for such exceptionalism is “not only scant, but fundamentally misplaced”.

Well-intentioned but possibly flawed changes to the regulatory environment, particularly the wage-setting framework, “run the risk of entrenching higher inflation in Australia compared to elsewhere.”

High frequency data such as the NAB monthly business survey – while down a little from extremely elevated levels — continue to indicate considerable wage and price momentum into 2023.

Citi has also upped its Australian inflation and interest rate forecasts after the blowout CPI data.

The US bank now expects year-ended headline inflation of 5.4 per cent and underlying inflation of 5 per cent, 1.4 and 1.3 percentage points above its previous forecasts.

It now sees a terminal cash rate of 3.85 per cent in April – implying another 75 bps of rate hikes, after previously expecting a terminal rate of 3.35 per cent next month.

Chief economist Josh Williamson says Australian inflation remains “stubbornly high.”

Price categories sensitive to the labour market have “accelerated significantly, and this is closely linked to underlying inflation and also wages growth.”

The upside surprise, particularly in market based goods and services items, “suggests that strong underlying consumer demand is driving price rises.”

With the unemployment rate still near a multi-decade low, it will put pressure on labour costs and for firms to maintain profit margins and the “risk is that inflation psychology is broadening, and the probability of a prices wage spiral is increasing.”

Ahead of the February monetary policy meeting, Williamson also saw a “hawkish risk of a 50 basis point hike by the RBA.

“While the Bank has recently stepped down its pace of rate hikes, the minutes show that in each meeting the Bank has still considered a 50 bps increase,” he says.

“If the Bank’s liaisons feedback suggests that prices-wage spiral is emerging, the RBA could again be convinced that the most prudent action is to raise the cash rate by 50 bps.”