Markets expecting more rate rises after a change in the RBA’s message

Returning inflation to target is central to the RBA’s thinking as it dialled up its concerns about rising prices.

RBA governor Philip Lowe. Picture: Bloomberg

Returning inflation to target is front and centre of RBA thinking as it dialled up its concerns about price increases and warned of further rate hikes while delivering another widely expected increase to the cash rate.

Even after lifting the cash rate a total of 3.25 per cent since May to a decade high of 3.35 per cent on Tuesday – the fastest pace of rate rises in Australia since 1990 – Governor Philip Lowe said the RBA board “expects further increases in interest rates will be needed over the months ahead …”

After underlying CPI inflation exceeded the Reserve Bank’s forecast for the December quarter – up 6.9 per cent year-on-year versus 6.5 per cent forecast – the board’s previous assessment, that policy is “not on a preset course”, was dropped from the February statement.

That suggested the RBA plans to get on with the job unless the economic data are surprisingly weak.

“This change implies that the RBA board has essentially made up their mind and intend to raise the cash rate further over coming months, if the economic data prints in line with their updated forecasts,” said CBA’s head of Australian economics Gareth Aird.

Several banks, including CBA, lifted their terminal rate forecasts up to 3.85 per cent, and NAB said it may go to 4.1 per cent, depending on the outcome of the NAB Monthly Business Survey next week.

Combined with a rise in the market-implied terminal rate to 3.96 per cent this August, a new consensus for economists of 3.85 per cent should give slightly lower inflation outcomes than the RBA’s updated forecasts on Friday, which will have been conditioned on a market/economist rate path peaking closer to 3.60 per cent.

But while the RBA said its mid-2025 forecasts will show a fall in headline CPI inflation to the top of its 2-3 per cent target band, it remains to be seen if the RBA’s updated forecasts still predict that inflation peaked at 7.8 per cent in the December quarter and will fall to 3.25 per cent by end-2024.

The RBA maintained headline inflation will still fall to 4.75 per cent by the end of the year.

If it were to lift its end-2024 forecasts of 3.25 per cent for headline and underlying inflation, it may give markets another minor hawkish jolt on Friday.

“We believe the governor’s statement leans more hawkish,” said Citi Australia chief economist Josh Williamson. “We believe upward revisions to underlying inflation forecasts are expected on Friday.

“Higher inflation and a still-tight labour market suggests that the board will likely need to hike twice more by 25 basis points in March and April, for a terminal policy rate of 3.85 per cent.”

Underscoring the need to return inflation to the target band, Lowe said high inflation “makes life difficult for people and damages the functioning of the economy”.

Westpac chief economist Bill Evans said by excluding “not on a preset course” from its statement, the RBA seemed “very clear” that it expected to increase the cash rate again in March.

But that’s consistent with his call that the cash rate will be increased on two further occasions in March and May, the last move coming as a response to the March quarter inflation report.

One surprise economic outlook was Lowe’s assessment that the recovery in spending on services following the lifting of Covid restrictions has “largely run its course”.

“This conclusion is not apparent in the data so far with the surprise collapse in retail spending in December relating to household goods, clothing, and department stores rather than any cooling in services spend,” said Evans.

Aird said a 3.85 per cent cash rate would be “deeply restrictive” and risk a recession. “The budgets of many home borrowers will be under considerable strain over the coming year,” he said. “We think policy easing will be required in Q4 23 if Australia is to avoid a hard landing.”

CBA still forecasts 0.5 per cent of rate cuts in the December quarter of 2023 and a further 50 basis points of cuts in the first half of 2024.

Aird said the surprise was not in the decision, but rather the shift in tone and forward guidance.

In his view, the removal of the previous reference to rates not being on a preset path “implies that the RBA board has essentially made up their mind and intend to raise the cash rate further”.

The fourth quarter inflation report has caused the board to shift their stance, but concerns over inflation becoming entrenched have “ratcheted up a notch”, according to Aird.

“To be clear, we do not share those same concerns. We believe that the RBA’s 300 basis points of rate hikes between May and December had very little impact on price changes in the economy over 2022.”

High inflation last year “largely reflected the massive fiscal splurge over 2020 and 2021, coupled with ultra loose monetary policy, to support the economy through the pandemic.”

The war in Ukraine also played a role in boosting prices through supply side disruptions, and the pandemic itself disrupted supply chains more generally, while floods on the east coast of Australia, also boosted prices for some food items in late 2022.

“The key point is that rapid interest rate hikes in 2022 will impact demand for goods and services in the economy and by extension price changes in 2023 and 2024,” Aird said. “Monetary policy tightening did not impact price outcomes in 2022.”

With the cash rate heading to 3.85 per cent, he sees the unemployment rate rising to 4.5 per cent unemployment rate and the inflation rate falling to 3.5 per cent by the end of 2023.

“It takes time for rate hikes to impact home borrower cash flow and by extension spending decisions,” Aird said. “Far more borrowers than usual are on fixed- rate mortgages, which blunts the initial impact, but fixed-rate home borrowers aren’t insulated from rate hikes indefinitely. But the RBA appears to have shelved the notion of pausing soon.”