Why markets are now ruling out another rate hike by the RBA

Economists and financial markets are ruling out a resumption of interest rate hikes in Australia after the underlying rate of inflation resumed its decline.

Economists and financial markets are ruling out a restart of interest rate hikes in Australia, after the nation’s underlying rate of inflation resumed its decline, despite being well above target levels.

Amid heightened attention on the interest rate outlook after the nation’s economic growth and disinflation progress stalled in the first three months of the year, the closely-watched “trimmed mean” measure of price increases fell to 3.9 per cent from 4.0 per cent in the March quarter.

The local sharemarket soared as bond yields and the Aussie dollar dived after core inflation undershot expectations that it would be stuck at 4.0 per cent for a second-consecutive quarters.

Australia’s S&P/ASX 200 share index soared 1.8 per cent to a record high of 8092.3 points. It was the biggest one-day rise in the local shares market since November 2022. It came as the three-year Australian government bond yield fell 25 basis points to a four-month low of 3.73 per cent.The 10-year yield fell as much as 19 basis points to a four-month low of 4.1 per cent.

The Australian dollar fell about half a US cent to US64.83c.

The outsized reaction came after a minority of financial market participants had bet that slightly higher inflation data would trigger a restart of interest rate hikes as monthly inflation indicators exceeded estimates and the labour market remained strong in recent months.

Money market pricing swung from implying a 31 per cent chance of a 25 basis point rate hike by the September RBA meeting to more than fully pricing in a 25 basis point rate cut by the February 2025 meeting. More than 50 basis points of rate cut were expected by the July 2025 meeting.

More than two years after the RBA began lifting interest rates as inflation soared during the pandemic, Australia’s inflation rate remains high by international standards and well above the RBA’s 2-3 per cent target. The 3.9 per cent underlying inflation rate exceeded the RBA’s 3.8 per cent forecast.

However, while economists said inflation is still too high for the RBA to start openly discussing the case for interest rate cuts, a “late cycle hike” can be ruled out as inflation is falling and there’s no evidence of a prices-wages spiral or significant increase in inflation expectations.

Betashares chief economist David Bassanese said the inflation data were “better than feared” and “good enough to rule out an interest rate hike by the RBA next Tuesday”.

“Those with a mortgage can breathe a sigh of relief, at least for now, though Australia retains a sticky inflation problem and interest rate increases at some stage this year can still not yet be confidently ruled out,” Mr Bassanese said.

“Today’s numbers are not bad enough to likely require the RBA to revise up its inflation forecasts within next week’s August statement on monetary policy.”

While inflation remains “uncomfortably high” the slight fall in underlying inflation will allow the RBA to maintain that it will fall back within the target band by late 2025.

Citi Australia chief economist Josh Williamson said the RBA will breathe a sigh of relief as inflation remains on-track to moderate down below the top of its 203 per cent target band by the December quarter. However, the RBA can’t afford to ditch its hawkish policy bias just yet.

“The RBA will not need to push out the timetable for CPI at the August statement on monetary policy,” Mr Williamson said. “This means the RBA can keep the cash rate target unchanged at 4.35 per cent, now likely to be the peak of the cycle, for the entirety of this year.”

But market-based inflation remains high and retail sales and credit data beat estimates.

“Households now have tax cuts and with further fiscal expansion likely this year ahead of elections, it is too early for the RBA to signal that the next move is down,” Mr Williamson said.

Persistent price pressures in categories such as services were more closely linked to the labour market. Housing inflation was unlikely to decelerate in the near-term because of population and capacity constraints. Progress on goods disinflation was slow in the first half, though Citi expects more moderation in the second half on discounting in categories such as clothing and furniture.

NAB said the details showed ongoing signs that inflation in those parts of the basket most sensitive to domestic demand conditions and most exposed to domestic cost pressures “are at the very least not re-accelerating and more likely heading in the right direction” despite “stubbornness” in rents, house construction and insurance price inflation.

“Subsets of the basket most exposed to domestic labour market conditions also moderated and inflation in those parts of the basket that tend to be least persistent were much stronger than they were last year,” NAB senior economist, Taylor Nugent said.

“All of that together means there should be little if any upward pressure on the RBA’s 2026 inflation forecasts on the back of this data.”

The most elevated price categories were “volatile components” like fuel, travel and fresh food, or “inertial components” like rents, and not components that the RBA should take too much signal from as it assesses progress in returning demand and supply to a more balanced setting.

He expects the RBA to keep forecasts for inflation around the midpoint of the target by 2026 and is likely to temper some of the discussion of upside risk to the inflation outlook.

“That all but removes the risk the RBA feels compelled to hike further, but even as today’s data was better than feared, inflation remains too high, and has shown less progress than the RBA had been expecting,” Mr Nugent said. “The conditions for a cut remain a long way off.”