RBA shows some patience with a return to neutral territory

Pendal

October 2022

The Reserve Bank of Australia (RBA) surprised the market this month when raising the cash rate by 25 basis points to 2.60%.

The market had assigned an 85% probability of the RBA hiking by 50 basis points.

Governor Lowe dropped a hint last month that the pace of tightening would slow when he commented that "the case for a slower pace of increase in interest rates becomes stronger as the level of the cash rate rises".

The market rallied following this comment which indicated 25 rather than 50 was more likely to happen in the nearer term.

Yesterday's 25bp hike means the RBA has now raised rates from 0.1% to 2.6% in 5 months. This is now seen as the bottom end of neutral territory.

Markets were looking for a 50bp hike given the hawkish party happening globally, led by Jerome Powell and his recent 75bp hike.

It was a case of a rising tide lifts all boats. As the following graph shows, central banks globally continued to tighten monetary policy aggressively in September.

In Sweden the Riksbank tightened by a more than expected 100 basis points.

The Federal Reserve, Bank of Canada, European Central Bank and Swiss National Bank (the last remaining member of the negative interest rate policy club) all raised their rates by 75 basis points.

The RBA, Bank of England and Norges Bank were all in the 50 basis point hike camp last month.

However, unlike other central banks, the RBA has shown some patience with this move. Rate hikes normally take 2 to 3 months to show up in any data given lags between the RBA hikes and the higher rates hitting mortgages.

One of the key lines out of the statement yesterday was "One source of uncertainty is the outlook for the global economy, which has deteriorated recently".

The UK Government's mini budget released last month was the source of much financial turmoil last month, the moves (and lack of liquidity) were astonishing late in the month.

The RBA is also acutely aware of the large amount of fixed rate mortgages that roll off over 2023.

The national accounts also reflected a drop in the household savings rate, indicating that the large savings buffers that households have built over the past 2 years may start to be called upon as cost of living pressures rise.

The decision to raise by a less than expected 25 basis points yesterday resulted in the market pricing in a terminal cash rate of 3.6% in 1 years time. At the end of September this was around 4.1%.

Back around neutral the RBA now thinks it has time on its side.

Their hope will be for better behaved CPI numbers in the quarters ahead.

The Sep Quarter CPI, due out later this month, should show elevated yet slowing CPI.

Our initial forecast is for a 1.4% increase, although electricity subsidies in WA and Victoria, and a lesser extent Queensland, could mean a lower number.

1.4% would be no cause for celebration but after a 2.1% and a 1.8% in recent quarters it is in the right direction.

Governor Lowe will likely take his next round of speeches reiterating their preparedness to tackle inflation with above neutral rates if needed.

"The Board remains resolute in its determination to return inflation to target and will do what is necessary to achieve that" was the final line of yesterday's decision.

For now though, reopening of supply chains, anchored inflation expectations and falling commodity prices are working in their favour.

The key domestically will be how tight labour markets feed into wage outcomes over the next year.

The RBA is prepared for 3.5% to 4% increases to wages, as many agreements are now showing, but will be alert for any trend higher.

Immigration is making a welcome comeback and may well impact enough in the next 12 months for the RBA to get their way.

However, the jobs market is unlikely to be back at pre COVID conditions until 2024 so the RBA patience, although welcome, may be tested again.

Author: Tim Hext, Portfolio Manager and Head of Government Bond Strategies

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