What lies ahead for interest rates as the Reserve Bank ups anchor?

The Reserve Bank’s monetary policy outlook is still quite hawkish despite the pause in July.

The Reserve Bank’s monetary policy outlook is still quite hawkish despite the pause in July.

Every monthly policy statement from July 2022 to May 2023 said: “medium-term inflation expectations remain well anchored, and it is important that this remains the case.”

But that line was removed from the June statement, implying that the RBA was no longer confident that inflation expectations were still “well anchored”.

That caused an upshift in terminal RBA cash rate pricing, a sharp lift in the Australian dollar and a sell-off in Australian shares and bonds, albeit the local share market was supported by a strong US market. It’s not clear what it will take to restore the RBA’s confidence that inflation expectations will remain anchored, preventing a prices-wages spiral. Meanwhile there’s upside risk for interest rates.

While announcing an increase in the cash rate to 4.1 per cent in June, RBA Governor Lowe warned that “if high inflation were to become entrenched in people’s expectations, it would be very costly to reduce later, involving even higher interest rates and a larger rise in unemployment.”

He also said that “recent data indicate that the upside risks to the inflation outlook have increased”, with the jobs market “very tight”, the award wage increase “higher” than last year, and wages growth consistent with the inflation target “provided that productivity growth picks up”.

Dr Lowe didn’t repeat the line that “upside risks to the inflation outlook have increased” this month.

There’s no clear evidence that those risks have increased in the past month, but they certainly haven’t gone away after just one more interest rate hike of 25 basis points.

Despite a 4 percentage point increase in the cash rate, the unemployment rate is still about 1 percentage point below the RBA’s estimated non-inflation accelerating rate, unit labour costs are surging along with the price of electricity, housing and rents, and deglobalisation and decarbonisation threaten to put longer-term upward pressure on inflation.

Dr Lowe’s comment this month on “the uncertainty surrounding the economic outlook” may have hinted that the board feels the economy could be at a tipping point.

Then again, as many have observed, the RBA usually delivers more dovish statements when they ease policy or hold, and more hawkish statements when they tighten interest rates.

UBS Australia chief economist, George Tharenou, expects the RBA to lower its economic growth forecasts by a cumulative 0.5-1 per cent and raise its unemployment rate forecast close to 5 per cent for the end of 2025 in its updated economic forecasts in August.

But the RBA’s revised economic forecasts, likely to be based on a higher cash rate assumption, are still expected to show inflation remaining above the central bank’s 2-3 per cent target until 2025, according to Mr Tharenou. That won’t be seen as a “reasonable time frame” leading the RBA to hike again, particularly since the forecasts will be based on a higher cash rate assumption.

In his view the RBA won’t need to lift the cash rate again to keep hiking thereafter, unless inflation “remains more sticky” than expected in the September quarter.

Looking further out, Mr Tharenou still expects the RBA to “hold at a peak level for longer-than-normal”, with the interest rate cut of this cycle not expected to come until May 2024.

He sees 75 basis points of rate cuts from the RBA by the end of 2024, lowering the cash rate to 3.6 per cent. But Mr Tharenou says the market pricing is “underpricing” the risk of a hike in August.

Mr Tharenou now has an enviable track record of correctly predicting every interest rate move by the RBA since July 2022, including the last five decisions that were “non-consensus.”

But it’s fair to say that none predicted a year ago that the RBA’s cash rate would be at 4.1 per cent by now. The cash rate is still well below the inflation rate in Australia – implying that real interest rates are negative and it’s still well below equivalent monetary policy rates overseas.

Meanwhile, China’s post-pandemic rebound is stumbling in a way that Western economies didn’t.

Even its services sector, a bright spot earlier this year, fell below pre-pandemic levels.

While still in “expansion” territory, the China’s Caixin Services PMI for May fell to 53.9 versus 56.2 expected by economists the official Composite PMI falls to 52.5 from 55.6

But could this bad news lead to stronger and broader stimulus in China?

“This provides further confirmation that the Chinese economy is slipping towards a double dip slowdown and that further stimulus measures are required to reverse the spiral,” said IG chief market strategist, Tony Sycamore. “In the short term, it’s not great news for the AUD/USD or the ASX200, but it will provide support to both on expectations of an imminent policy response.”

Capital Economics said policy support will be key to preventing a further deceleration in growth.

“Aside from some token rate cuts, officials have so far been slow to announce meaningful stimulus,” said the economic forecaster’s head of China economics, Julian Evans-Pritchard.

Thursday’s State Council meeting reportedly discussed measures to boost consumption as well as spending on urban renovation projects, but unless concrete support is rolled out soon, the recent downturn in demand risks becoming self-reinforcing, he added.