RBA governor Philip Lowe charts challenge of a soft landing for the economy

A soft landing is certainly possible, but the path ahead is a narrow one and it is clouded in uncertainty, RBA governor Philip Lowe says.

The Reserve Bank has acknowledged the difficulty of achieving a soft landing for the economy as it lifts interest rates to head off a potential rise in inflation expectations.

In a speech to The Australian Strategic Business Forum in Melbourne, RBA Governor Philip Lowe said “the policy challenge” for RBA is to “return inflation to the 2–3 per cent target range while, at the same time, keeping the economy on an even keel.”

“We don’t need to return inflation to target immediately, as we have long had, for good reasons, a flexible medium-term inflation target,” he said.

“But we do need to chart a credible path back to 2–3 per cent.”

“We are seeking to do this in a way in which the economy continues to grow and unemployment remains low.”

“It is certainly possible to do this, but the path ahead is a narrow one and it is clouded in uncertainty,” he added.

While noting that the RBA is “not on a pre-set path to achieve any specific level of the cash rate”, Dr Lowe also said the Bank is “determined to do what is necessary to return inflation to 2–3 per cent.”

“If inflation expectations shift up and businesses and workers come to expect higher rates of inflation on an ongoing basis, it will be harder to return inflation to target – doing so would require higher interest rates and a sharper slowing in spending,” he said.

“It is in our collective interest that this does not happen.”

While there’s considerable uncertainty about the “neutral real rate” of cash – the inflation-adjusted rate that doesn’t change the economic outlook – most of the RBA’s models for Australia suggest it’s “at least positive”, he said.

Based on the 2½ per cent midpoint of the inflation target – “a reasonable estimate of medium-term inflation expectations”, he noted that the “neutral nominal rate is at least 2½ per cent.”

“It would be higher than this if medium-term inflation expectations were to shift higher,” he added.

However, the “concept of the neutral rate is no more than one reference point for the Board.”

“It is not the basis of a mechanical rule and we are not on a pre-set path to achieve any specific level of the cash rate,” Dr Lowe said. “Rather, the Board will continue to be guided by the incoming evidence and by its assessment of the outlook for inflation and the labour market.

It comes after the RBA increased the cash rate by 125 basis points over its past three meetings to lessen the extraordinary monetary support that was put in place to help the Australian economy during the pandemic after inflation exceeded its target band.

Since then, NAB’s monthly business survey showed product price growth strengthened and retail price inflation remained elevated, leading NAB to warn of a “very high print” for underlying inflation when the June quarter data are released next Wednesday.

In addition, Australia’s unemployment rate plunged to a lower than expected 3.5 per cent – a fresh 48-year low — prompting some economists to call for a 75 basis point rate hike in August.

Some revised up their forecasts for the peak rate of cash set by the RBA, while others acknowledged “upside risk” to their forecasts, and were awaiting the CPI data before adjusting their forecasts.

Dr Lowe did see “a reasonable basis to expect that Covid-related disruptions to global supply chains will ease further over the months ahead.”

Delivery times were improving and some supply bottlenecks were easing, and the effects of this and some rebalancing in consumer demand are now evident in some global markets, with declines in the global prices of products as diverse as computer chips and timber.

Prices of many commodities have also declined over the past few weeks amid increased concerns about the strength of the global economy and some easing of supply problems.

“If the lower prices are sustained, this will ease some of the current global inflation pressures,” Dr Lowe said. “Even so, it remains possible that there will be further interruptions to global supply, once again pushing up prices; the European gas market is a particular area of concern here.”

Domestically, he said that with the lowest unemployment rate in nearly 50 years, declining underemployment and record job vacancies, the economy may have exceeded “full employment” – implying a potential rise in wages that could lead to a wage-price spiral.

“This all suggests that the growth in demand in the Australian economy is pushing up against the capacity of the economy to meet that demand,” he said.

For inflation to return to the 2–3 per cent target range, a more sustainable balance between demand and supply is needed,” Dr Lowe noted.

“Higher interest rates will help achieve this through moderating growth in aggregate demand.”

“With the Covid emergency now over, so too is the time for emergency settings of monetary policy,” Dr Lowe said. A “robust recovery” has taken place and “the time for ultra-low interest rates is now behind us given that inflation is high and the labour market is very tight.”

“These increases will help establish a more sustainable balance between demand and supply in the Australian economy,” Dr Lowe said.

Nomura senior economist and rate strategist, Andrew Ticehurst, said Dr Lowe’s comments should “lead more dovish analysts to continue to revise up their own cash rate profiles, towards our own” and could lead the market to “consider the possibility of an even higher cash rate.”

“In summary, today’s comments from the Governor perhaps spell out more clearly that the RBA expects to take the cash rate into restrictive territory, by moving it above 2.5 per cent,” he said.

“This is already our expectation – we have the cash rate peaking at 3.35 per cent by end-2022 – and the market is pricing even more – a cash rate of approximately 3.54 per cent by end-2022 and 3.80 per cent by April next year – the current peak.”