Opinion divided over Reserve Bank’s next move on interest rates

Michele Bullock has all but ruled out interest rate cuts in the next six months, so why do Commonwealth Bank and the money market still expect the RBA to cut before year end?

Michele Bullock has all but ruled out interest rate cuts in the next six months, so why do the Commonwealth Bank and the money market still expect the RBA to cut before year end?

Some of the more extreme market pricing of interest rate cuts this week was due to the sharp fall in stocks sparked by US recession fears after a disappointing US non-farm payrolls report.

That accelerated an exodus of yen “carry trades” that began after the Bank of Japan started lifting interest rates and buying yen after it hit four-decade lows. However, while economists continued to push out their expected timing of RBA rate cuts after its hawkish guidance this week, the money market was almost fully pricing a rate cut by year end, and about three cuts over the next 12 months.

After its meeting this week, the RBA board left the cash rate unchanged at a near 13-year high of 4.35 per cent. The decision was no surprise as Australia’s underlying inflation rate for the year to June remained well above the 2-3 per cent target band even as it hit a two-year low of 3.9 per cent.

The RBA noted that underlying inflation has been above the middle of the band for 11 consecutive quarters and has “fallen very little over the past year”, even as higher interest rates have been “working to bring aggregate demand and supply into better balance”.

The central bank also revised up its inflation forecasts, predicting it won’t approach the midpoint of the target band until the end of 2026 – six months longer than previously forecast.

The RBA increased its inflation forecasts because “the gap between aggregate demand and supply in the economy is larger than previously thought” because the RBA increased its demand forecast and the economy’s ability to meet that demand “is somewhat weaker than previously thought”.

Economic growth slowed to 1.1 per cent in the March quarter versus a long-term trend of 3.4 per cent. But in her post-meeting press conference, Ms Bullock said the board gave “very serious consideration” to a rate rise at its meeting and “will increase interest rates” again if needed.

Bullock amplified that hawkish message in a speech in Armidale, saying the RBA “will not hesitate” to lift interest rates again if needed to stop inflation from becoming “persistently high”.

Westpac pushed out its forecast on the timing of the RBA’s first interest rate cut to February.

“The RBA governor all but ruled out cutting rates this year,” Westpac chief economist, Luci Ellis said.

“Our forecasts for underlying inflation are the same as the RBA’s August forecasts, but we are more pessimistic about consumption growth and less concerned over productivity,” Dr Ellis said.

“The underlying logic of our framework is that monetary policy works with a lag,” she added.

“If you wait until you are back at target before starting to cut rates from a restrictive point, you have waited too long. So the question is how much evidence policymakers need to see to be convinced that inflation is on track to return to target on the desired timetable?”

Ellis was previously assistant governor economic at the RBA.

However, CBA’s head of Australian economics, Gareth Aird, stuck to his long-held call for a cut in November and 125 basis points of cuts by the end of 2025.

CBA was the only one of the big four banks still expecting the RBA to cut rates this year.

While noting that the risk sits with a later start date to interest rate reductions, based on the RBA’s hawkish guidance, Mr Aird said the central bank has “underappreciated the impact that the savings drawdown has played in supporting household consumption since the economy reopened”.

“As a result, we believe the RBA is overestimating the extent to which Stage 3 tax cuts will push spending higher given the savings drawdown will be essentially over by the end of the year,” he said.

In its Statement on Monetary Policy, the RBA said growth in household consumption remains well below pre-pandemic averages but has been “stronger than previously thought”.

Real household income has stabilised as a result of inflation declining, as well as slowing in the pace of interest rate and tax payment increases.

“Both real household income and wealth are expected to grow strongly over the forecast period; real household disposable income growth is expected to increase notably from mid-2024 as a result of the Stage 3 tax cuts and further declines in inflation,” the RBA said.

But Mr Aird estimates that the stock of additional savings accumulated during the pandemic period – relative to the normal trend – will be largely exhausted by the end of 2024.

He thinks the boost to consumer spending power in financial 2024/25 from the July 1, 2024 tax cuts will be partially offset by the decline of the tailwind on consumption from the savings drawdown that started in the December quarter of 2022.

Moreover, Australian household spending growth is expected to remain weak until the RBA starts cutting rates, with consumer confidence unlikely to pick up in any meaningful way until interest rates are cut and economic growth returns to a trend‑like pace.

The economic outlook is “finely poised at the moment” with “incredibly weak private demand growth” offset by strong growth in public demand or government spending. The economic tailwind from a drawdown in abnormally-high savings accumulated via excess mortgage repayments and payments into offset accounts during the pandemic doesn’t have too much further to run.