Rate hike risk set to linger as lower inflation figure fails to convince analysts

Lower-than-expected inflation fuelled a rebound in Australian shares, but the Aussie dollar and bonds soon regained pre-CPI levels as the data didn’t remove the risk of rate hikes.

Lower-than-expected inflation data fuelled a rebound in Australian shares, but the dollar and bonds soon regained their pre-CPI levels as the data didn’t remove the risk of rate increases.

Meanwhile, Future Fund chair Peter Costello warned that inflation pressures “remain strong”.

Interest rates were likely to “stay elevated” in developed economies, even as the full impact of higher rates was yet to be seen and recessions remained a risk, as central banks stayed vigilant on inflation.

The outlook for China’s economy is the biggest concern for the Future Fund.

But it was “far too early” to say that Australian interest rates have peaked, Costello said.

Of course, the Reserve Bank can cite the fall in the monthly CPI indicator, to an annual rate of 4.9 per cent in July, as a reason to keep interest rates on hold again next month as it gauges the economic impact of its aggressive rate rises and effects on wages and ­prices of legislated wage increases this quarter.

However, the further rapid decline in the inflation indicator from 5.4 per cent in June and a three-decade high of a peak of 8.4 per cent in December (it also undershot market expectations of 5.2 per cent) was magnified by the impact of electricity subsidies and sharp falls in volatile items.

If not for the Energy Bill Relief Fund, which gave eligible households rebates ranging from $43.75 to $250 in July, electricity prices would have risen 19.2 per cent on-month, rather than 6 per cent.

Also, the survey leaves out 35 per cent of the CPI basket in July, and is heavily weighted to goods.

“Today’s result benefits from progress on disinflation across goods, but captures less of the stickiness in services prices which we expect to be evident in the ­August indicator and the full quarterly CPI,” NAB economist Taylor Nugent said.

On a three-month annualised basis, the increase in the seasonally adjusted CPI excluding volatile items and holiday travel rose from 3.7 per cent to 5.09 per cent, which was well below a peak of 8.3 per cent late last year, but still well above the RBA’s 2-3 per cent inflation target.

“It suggests underlying price pressures remain somewhat above the RBA’s 2-3 per cent target,” said Goldman Sachs Australia chief economist Andrew Boak.

Boak said the RBA’s “reaction function” – how policy is adjusted in response to evolving economic developments – had in recent years been much more volatile compared to its history and that of other central banks, such that economists and markets had frequently been wrong-footed.

Even though interest rates have risen rapidly to a decade high of 4.1 per cent, from a record low of 0.1 per cent, since May last year, the RBA’s reaction function had “actually been surprisingly dovish”.

The RBA would have been expected to tighten even more aggressively based on what would be implied by a “Taylor rule” as well as the reaction of other central banks to tight labour markets, above potential economic growth and soaring inflationary pressures since the Covid pandemic.

Using the Taylor rule embedded in the RBA’s MARTIN model, Boak estimated that the RBA’s current macro forecasts were consistent with a peak cash rate in the 4.75-5.75 per cent range.

Compared to its peer central banks in developed markets, the RBA’s own forecasts reflect a preparedness to tolerate a materially larger inflation overshoot to the end of next year.

Consistent with the RBA’s ­dovish stance on inflation, in the past 12 months Australian break-even inflation rates have risen versus global peers and the yield curve has been relatively steep.

Looking ahead, Boak expects the implementation of the RBA review to improve transparency, accountability and reduce volatility in the central bank’s reaction function.

In particular, the review-recommended change to shift the inflation target to the 2.5 per cent midpoint of the 2-3 per cent target band – which is 50 basis points below the 3 per cent upper-bound that the RBA has been guiding to – had a “hawkish read-through for monetary policy in the current high inflation environment”, according to Boak.

“On face value, analysis using the RBA’s MARTIN model suggests the cash rate would need to rise to around 5.75 per cent to see underlying inflation fall to 2.5 per cent by the end of 2025, compared to its current forecast of 2.8 per cent on-year,” he said.

These sensitivities should be taken with a large grain of salt given the uncertainty around the MARTIN model’s ­parameters, as well as potential downside risks to inflation from other factors.

With Michele Bullock taking over as RBA governor on September 18, there’s added uncertainty about how the bank will navigate the most significant institutional change in 30 years.