Why the Reserve Bank RBA isn’t finished with increasing interest rates

It would be a mistake to think that interest rate rises have reached their peak and cuts are coming anytime soon.

Westpac chief economist Bill Evans. Picture: John Feder

No doubt the Reserve Bank is getting closer to the end of its monetary policy tightening.

But it would be a mistake to think that rate increases are done and cuts are coming any time soon.

After last month’s pause to assess the impact of the increase in interest rates to date and the economic outlook, the minutes of the July board meeting strongly validated the decision, as usual.

That shouldn’t be confused with a further softening of the tightening bias that has delivered two rate rises per quarter so far this year. Economists still expect to see two more.

For the first time this cycle, the RBA said the current level of the cash rate was “clearly restrictive” after monetary policy was “tightened considerably and rapidly over the prior year”.

The full effects of the rapid lift in the official cash rate since May 2022 – from a record low of 0.1 per cent to a decade high of 4.1 per cent – were “yet to be observed”.

“When central banks make decisions that are somewhat surprising they will always make a strong case to support that decision,” Westpac chief economist Bill Evans said.

“These minutes are no exception, with the case to hold rates steady strongly ­promoted.”

While the minutes gave more prominence to the possible downside risks to economic growth, the persistence of high inflation and tight labour market conditions “still look to be the main factors shaping policy decisions in coming months”, with two more rate rises likely, Mr Evans said.

The RBA board “noted that economic growth in Australia had slowed considerably, reflecting the impact of higher interest rates and high inflation”.

And while the case for another 25 basis points rate increase was considered alongside the “stronger” case to pause, the decision wasn’t characterised as “finely balanced” as it was previously.

An inversion of the bond yield curve was “consistent with a contractionary monetary policy setting,” the minutes said. “In addition, mortgage interest payments as a share of household disposable income were around a record high in May and would rise further as fixed-rate loans continued to mature, even if the cash rate was not increased further.”

The board “acknowledged that it takes time for households and businesses to adjust their spending and investment plans, and that there were still significant resets of low fixed-rate loans ahead”.

Demand for labour responds to monetary policy with a lag, implying that the current tightness of the jobs market “might also ease”. Inflation was “now declining, albeit from a high level” and this would “help mitigate the risk of a rise in medium-term inflation expectations”.

Falls in commodity prices and shipping rates in recent months had “reduced upstream cost pressures for goods”, the minutes said.

More broadly, the slowing in economic growth was working to bring demand and supply into closer alignment, which, over time, would lower inflation.

There was “considerable uncertainty about the resilience of household consumption” and “the squeeze on many households’ finances could result in consumption slowing more sharply than implied by the current forecasts”.

“Higher interest rates could be expected to encourage households to save more, which would hurt consumption and the demand for labour, pushing the unemployment rate well above the point required to ensure inflation returns to target in a reasonable time frame,” it said. Mr Evans said the increased prominence given to downside risks seemed “somewhat inconsistent” with economic data since the June board meeting, emphasising his point that the case to justify a decision is always strengthened in the board minutes.

Despite this strong justification for rates remaining on hold in July, the board concluded that “some further tightening of monetary policy may be required”, contingent on how the economy and inflation evolved, with updates on inflation, the global economy, the labour market and household spending of particular importance alongside the full refresh of RBA staff forecasts due in August.

“While omitting the language that the arguments in favour of hiking and pausing were ‘finely balanced’, the minutes reinserted the prior forward guidance that ‘some further tightening of monetary policy may be required’,” Goldman Sachs Australia chief economist Andrew Boak noted.

Members “reaffirmed their determination to return inflation to target within a reasonable time frame and their willingness to do what is necessary to achieve that outcome”, the minutes said.

Crucially, inflation was forecast to remain above target for an extended period and there was a risk that this time frame would be extended without further monetary policy tightening.

“Members noted that several CPI categories for which inflation was typically quite persistent already had too high inflation, including rent and services prices more broadly,” the minutes said.

“They also observed that weak productivity was contributing to strong growth in unit labour costs.”

A substantial rise in electricity prices from July was incorporated in the staff forecasts, but “there was a risk that the wider effects on inflation had not been fully ­captured.”

The jobs market “remained very tight” despite some easing in conditions in the preceding month. Nominal wage growth appeared to have stabilised recently, but “members assessed that the environment would remain conducive to above-average increases in prices and wages under such levels of labour market tightness”.

Inflation in advanced economies was “proving to be more persistent than expected” and central banks had responded with “unexpected or larger-than-expected monetary policy tightening” in June, the minutes said.

The policy rate in Australia was “still lower than in many comparable economies” and the recent experience of those countries “highlighted the upside risks” to inflation and interest rates.

“The case for a tightening is at its strongest when they point out that there is little spare capacity in the economy including in the labour market,” Mr Evans said.