Friday, 26 April, 2024
AFR – Chris Joye – You heard right – the RBA could raise rates again
You heard right – the RBA could raise rates again
The Reserve Bank of Australia will likely be forced to warn that it could raise rates again.
Christopher Joye
Apr 26, 2024 – 12.05pm
This week we were presented with yet more powerful data demonstrating that central banks are repeating past mistakes by encouraging an acceleration in consumer price pressures through their dovish prognostications. Australia’s central bank could be forced to fall into line with peers and raise rates again.
Back in 2021, policymakers repeatedly assured us that the massive inflation shock at that time was “transitory” because of its ephemeral supply-side origins, only to discover that they were embroiled in a multi-year battle against demand-side inflation fuelled by their own hyper-stimulatory monetary and fiscal policies.
In late 2023 and 2024, they ironically hinged their hopes on the same transitory goods price disinflation (or deflation) as supply chains reopened to buttress the belief they had slayed the dragon, paving the way for generous rate cuts this year. This precipitated the mother-of-all “risk” rallies in the form of soaring equities, bond, crypto and house prices, among other things.
Demand-side driven services inflation running at more than twice its normal levels has eviscerated dovish interest rate expectations, which, for now, risky asset prices are seeking to ignore.
The frustrating thing is that both the 2021 and 2023–24 mistakes were eminently avoidable. Prudent economic modelling has consistently warned that ultra-tight labour markets would power unsustainably strong wage growth that obliges services businesses to jack-up the price of their wares. Any lay business owner can now see that we are on the precipice of an insidious wage-price spiral, which the Fair Work Commission’s deliberations could shortly amplify.
The concern is that the longer central banks take to restore price stability, the more difficult the task becomes as elevated consumer inflation expectations, and hence future wage claims, get more deeply entrenched.
Central banks ‘humiliated’
Both the Reserve Bank of Australia and the US Federal Reserve have been humiliated this week by data blowing their dovish predispositions out of the water. In the March quarter, core inflation in Australia expanded by 1 per cent (or 4.1 per cent on an annualised basis after a 3.2 per cent rise in the December quarter), above the consensus projection for a 0.8 per cent bump. Over the 12 months to March, this trimmed mean measure of inflation climbed by 4 per cent, significantly above the RBA’s 2.5 per cent target.
What was even more distressing is that the official statistician’s new monthly (as opposed to quarterly) inflation gauge implies that core inflation is likely to remain elevated in the June quarter, pointing to another rapid increase of 0.9 per cent or more. Put differently, inflation is all but certain to stay hot for the foreseeable future.
The underlying drivers of inflation reveal that we face a long-term battle to get it under control. Coolabah’s experimental core “services” inflation proxy accelerated from 0.9 per cent in the December quarter to 1.5 per cent in March (or from 3.6 per cent on an annualised basis to 6.1 per cent), which is the largest quarterly increase in core services inflation that our benchmark has recorded since it began in 2000.
And it is a global phenomenon: core services inflation in Australia, New Zealand and the US is running at 6-7 per cent (as a consequence of similarly strong wage growth), which is about double the pace that prevailed before the pandemic when central banks were hitting their targets.
Juxtaposed against rampant services prices was more modest Aussie goods inflation of only 0.6 per cent in the March quarter, which kept the overall inflation rate lower than it might otherwise be. It is, however, noteworthy that neither Australia nor New Zealand are benefiting from the outright goods deflation (ie, declining prices) evidenced in the US.
Tax cuts bestow ‘unhelpful’ stimulus
The RBA’s challenge will be exacerbated by the fact that the income tax cuts in July will be the equivalent to around three 25 basis point interest rate cuts (75 basis points in total) if they are fully spent by households, which represents an unhelpful injection of stimulus at a juncture when we are grappling with the worst inflation crisis in decades.
If Martin Place is intellectually honest, which, to be clear, is never a sure thing, the March quarter inflation shock should result in a mechanical upgrade to its inflation forecasts such that it would not be able to realistically secure its 2.5 per cent target until late 2026. This is an absurdly long time and further undermines its already embattled inflation fighting credibility.
“Taking until the second half of 2026 to hit its target would be at odds with the RBA repeatedly stressing that ‘returning inflation to target within a reasonable timeframe remains the board’s highest priority’,” Kieran Davies, Coolabah’s chief macro strategist, highlights.
Arguably the best interest rate strategist in the market, Barrenjoey’s Andrew Lilley, asserts that “the RBA are very close to hiking – it is a line ball call”.
“The unemployment rate has come in 20 basis points below the RBA’s forecast while trimmed mean inflation has come in 20 basis points above,” Lilley explains. “These are the two things that the RBA targets, and a standard monetary policy rule would say that you need to hike for surprises this large.
“If the RBA truly has a ‘low tolerance’ for inflation taking longer than is currently forecast to return to band, then they should hike 18 months before this period is realised – this would be a hike at the May or June meetings.”
RBA to backtrack
Of course, it would be an enormous surprise to markets if the RBA actually did what it should do, which is precisely why its credibility is shot. The added complication here is that the RBA has set its 4.35 per cent policy rate way below the 5.0 to 5.5 per cent range imposed by key global peers, such as Britain, Canada, New Zealand and the US.
The RBA’s own macro models, and those of central banks like the Fed, which we run, recommend that the Aussie economy needs a cash rate around 5 per cent right now.
“High inflation combined with a 3.8 per cent jobless rate should see the RBA backtrack on its neutral policy and resume warning that it could raise rates again, something that Coolabah’s analysis has suggested they should have delivered on last year,” Davies says.
As former Bank of England governor Mervyn King once said, if you know what your next move should be, then you likely have the wrong rate right now.
Fed’s own sharp slap
“Our policy rule research indicates that the RBA should have followed its peers and raised rates to about 5 per cent,” Davies says. “Yet Martin Place purposefully decided to raise rates by less than its own outlook would imply was required to limit damage to unemployment.” One can only speculate that that is the deal Martin Place did with the devil that is its political masters to get an insider appointed as its governor.
On Thursday night the Fed received its own sharp slap across the chops. Its preferred core PCE benchmark for inflation printed at 3.7 per cent annualised compared to the consensus projection of 3.4 per cent. This hints at a strong March monthly result, which will be released during Friday’s US session, combined with upward revisions to the January and February data.
One US bank bond trader wrote that “if we weren’t in an election year, we would still very much be in a hiking cycle”. “Clearly the Fed does not need to cut – the labour market is incredibly tight, the financial conditions index is as easy as ever, and inflation is heading in the wrong direction.”
The US 10-year government bond yield, which is the global price of money, extended its march towards 5 per cent, breaching the influential 4.7 per cent technical barrier for the first time since October last year. While equities initially slumped as much as 1.6 per cent, they closed down only 0.6 per cent as investors kept their heads firmly in the sand.
Indeed, the market feels like it is trading very “long” and trying to defend this position, relentlessly reflexing into “hopeium”, encouraged by reckless central banks, that rate relief is always around the corner. One way or another, something has to give.
James Fay
Founding Partner
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