RBA must clamp down harder on consumer spending warns Westpac

Influential Westpac economist Bill Evans argues the RBA should aim to get inflation back down to 3 per cent next year but might need a significantly higher ‘terminal’ cash rate to achieve that.

Westpac chief economist Bill Evans. Picture: Daniel Pockett / The Australian

The Reserve Bank risks a damaging inflationary mindset taking hold unless it clamps down harder on consumer spending than its cash rate assumptions indicate, according to Westpac.

In detailed economic forecasts released with its August statement on monetary policy on Friday, the RBA assumes the cash rate will “increase to around 3 per cent by the end of 2022 and then decline a little by the end of 2024”.

The RBA raised the cash rate by 50 basis points to 1.85 per cent on Tuesday.

But even with its assumption of a further 115 basis point rise in its key monetary policy interest rate and little in the way of interest rate cuts through 2024, the central bank expects headline inflation to be well above the top of its target band in 2023 and at the top end through 2024.

Headline inflation is now expected to peak at 7.8 per cent in December – compared to its May forecast of 5.9 per cent – before falling to 4.3 per cent in 2023 and 3 per cent in 2024.

Economic growth is expected to slow to 3.2 per cent for 2022 (versus 4.2 per cent forecast in May), before falling to 1.8 per cent in 2023 (versus 2 per cent ­previously).

But the RBA lowered its unemployment forecast to 3.4 per cent for 2022, compared to 3.7 per cent tipped in May, while expecting a still relatively low 4 per cent in 2024.

Westpac chief economist Bill Evans said: “Of most interest is the acceptance that, unlike in May, headline inflation stays well above the top of the target band in 2023, and only just makes it in 2024.”

Westpac’s forecast that inflation will cool to 3 per cent in 2023 assumes a bigger increase in the RBA’s cash rate to 3.35 per cent by February 2023. It sees unemployment hitting 5 per cent in 2024.

“Our much weaker growth profile in 2023 allows the prospect of inflation falling back to near 3 per cent in 2023 – indicating that the bank would have succeeded in its inflation objective, albeit at a greater cost to economic growth in the short term,” Mr Evans said.

He insists that a sharper slowdown in demand is required in 2023 because “a much stronger set of demand conditions” and the RBA’s forecast of 2.4 per cent growth in consumer spending in 2023 “runs the risk of resilient high inflationary expectations”.

The RBA said: “One uncertainty affecting the outlook for inflation is the possibility that inflation expectations and general inflation psychology shift, and lead to the higher inflation being more persistent” but “longer-term measures of inflation expectations remain well ­anchored”.

However, Westpac’s Mr Evans argued that “there has already been a significant shift”.

Trade unions’ expectations for the 5 to 10-year period have lifted from 2-2.5 per cent to 3.5 per cent, while unions’ one-year expectations have lifted from less than 2 per cent to 6 per cent, the RBA said. But Mr Evans cautioned that employer assessments of the demand outlook and the preparedness of the RBA to clamp down on demand will be a “key determinant” of business’s propensity to raise prices and be more flexible with wage demands. RBA forecasts of 1.8 per cent growth and 4.3 per cent inflation in 2023 risked business being “emboldened to continue raising prices with demand conditions solid”, he said.

The RBA was seemingly “very patient in its inflation objective – apparently favouring the prospect of keeping the economy on an ‘even keel’ rather than addressing the paramount need to bring inflationary expectations back into line”. The Bank of England – dealing with an inflation rate forecast to hit 13 per cent this year – raised its bank rate by 0.5 per cent to 1.75 per cent even as it forecast a recession from the fourth quarter.

“We would like to have seen inflation and growth forecasts more consistent with a central bank that is determined to reach its inflation objectives over a shorter time period than 2½ years,” Westpac’s Mr Evans said of the RBA’s policy statement.

He argued that the RBA should aim to get inflation back down to 3 per cent in 2023 and if that required a significantly higher “terminal” cash rate “then they should use that rate in the forecasts”.

“That does not mean that the rate needs to be rapidly pushed through the assessed ‘neutral’ and into the contractionary setting, but it may mean that the bank expects it to take more time to reach its higher peak,” he said.

“It does not ‘feel’ right that the bank should be taking the cash rate forecast from the market and analysts and forecasting a mild slowdown and the need for 2½ years to reach even the top of the target band.”

Mr Evans said it would be “much more satisfactory to see a set of forecasts that indicated a much weaker demand climate in 2023 and a significantly more rapid achievement of the inflation target”. “From our perspective we believe that outcome would be achieved with a terminal rate of 3.35 per cent, 35 basis points higher than the rate used in the RBA forecasts,” he said. “Arguably, the bank believes a much higher rate would be required to achieve the objective,” he added.

“If so, we would have liked to have seen that rate used in the forecasts with the forecasts signalling the intention to get back to the top of the band by 2023.”

This approach would give “the best chance of managing this difficult task of returning inflationary expectations to more normal levels and deflating the current ‘inflationary psychology’ which is now at risk of taking hold”.