How Hard Will The RBA Now Go?

Australia | May 04 2022

Yesterday’s RBA rate hike was of little surprise, but the magnitude of it was, raising the question of just how fast the RBA will now move to “normalise” rates, and what the consequences may be.

-25 points hike not anticipated
-RBA and economists see a 2.5% rate ahead
-Just how fast will the RBA move?
-Mortgages on the line

By Greg Peel

From When Will the RBA Hike? April 6 (https://www.fnarena.com/index.php/2022/04/06/when-will-the-rba-hike/):

“There is no clue yet as to by what amount the RBA will hike. The obvious choice is an initial 15 basis points on top of the current 0.10% rate, to take the cash rate to a more familiar 0.25%, before standard 25 point hikes follow thereafter. But if the board is caught out by the strength of the upcoming numbers, vis a vis its own forecasts, it is not beyond the realms a 40 point hike will result, taking the cash rate straight to 0.50%.”

The above summarised economist consensus in April regarding the first RBA rate hike expected in June. The only reason economists expected the first hike in June rather than May was an RBA desire not to be seen influencing the election.

Unless, they conceded, the “upcoming numbers” referred to above came in a lot stronger than expected, then perhaps a May hike was not beyond the realms.

There were two sets of upcoming numbers economists suggested were critical to RBA policy. The first was the release of March quarter CPI data, and the second the March quarter wage price index. Only one would have been released by the May meeting – the CPI.

It came in at 5.1% year on year, when consensus had forecast 4.6%, up from 3.5% in the December quarter. Headline inflation came under pressure in the March quarter initially from omicron, but by the month of March, Putin. The ramifications of the war in particular on global commodity supply were underestimated.

Hence the 5.1% headline inflation print was a wake-up call for the RBA. The “trimmed mean” or core rate (ex food & energy) came in at 3.7% — well above the RBA’s 2-3% comfort zone. The “hot” numbers led economists to predict the RBA would be forced to ignore the election and bring the first cash rate hike forward to May, regardless of not having the most recent wage data at hand.

Arguably the only reason economists assumed an initial 15 basis point hike was it would bring the rate to 0.25%, such that thereafter more “standard” 25 points hikes could follow. But this was not to be the case. A once “patient” RBA went straight to an impatient 25 point hike to 0.35% — election be damned.

The clue is in the RBA’s revised economic forecasts. While the board now expects the trough in the unemployment rate will be 3.5%, down from a prior 3.75%, it has lifted its peak inflation expectation all the way to 6.0%, up from a prior 3.75%.

That’s reason enough for the board not to hang around waiting for the latest wage growth numbers. However, in Philip Lowe’s post-meeting press conference yesterday he did cite feedback from businesses suggesting wage growth was now running at 3% (annual) compared to the 2.3% recorded in the December quarter – the latest official data until June 1.

For many months Philip Lowe has pointed to weak wage growth as reason not to rush into rate hikes too soon, along with the fact Australia’s inflation was running well below levels suffered in other Western economies. But now, it seems, all has changed in a hurry.

Given the RBA has always (not including the 0.10% covid emergency rate) set the cash rate on 0.25% increments, a cash rate of  0.35% is unusual enough for economists not to have forecast such a move. When asked about it at the press conference, Lowe shrugged off a 25 point hike as “business as usual”, irrespective of the odd mid-range rate.

This could suggest that rate hikes from here might all be 25 points, continuing the “business as usual” theme. The RBA is not inclined to deviate from standard 25 point hikes, unless, Lowe said, there is “a very strong argument to do so”. But that’s not what economists expect. Economists suggest something more underhand is afoot.

Harking back to the extract above, the implication was that on the assumption of a 4.6% March CPI print, the RBA would target a 0.50% cash rate, possibly by June but at least by July. But given the 5.1% inflation result, it is assumed the RBA wants to get to 0.75% quick smart. Hence consensus sees a 40 point post-election hike in June to 0.75% as quite possible, given the unexpected 25 point jump yesterday which can at least, pre-election, be shrugged off as “business as usual”.

The first main “argument” will come with the March quarter wage price index, followed by the March quarter GDP numbers.

When will it all end?

At his press conference, Philip Lowe reminded that he had previously suggested the current neutral rate was 2.5%.

The “neutral” rate, also known as the “terminal” rate, is a utopian concept of an equilibrium rate which is neither stimulating nor constricting economic growth. It’s the rate that comes with a bowl of porridge. Given economies only ever travel through boom-bust cycles, the neutral rate is only a rate that’s passed through briefly on the way up and way down.

But it’s a guide.

While Lowe also reminded that he had previously not set any timeline for his expectation on when the neutral rate would be reached, yesterday’s RBA forecasts suggested by end-2023, with 1.50-1.75% by end-2022 on the way. In other words, the RBA expects to keep hiking from 0.35% to reach 2.5% by the end of next year.

It will, however, depend entirely on what happens between now and then. Variables include the length of the war, the length and extent of Chinese lockdowns and – heaven forbid – another new strain of covid appearing to send Melbourne into lockdown, to name only the obvious ones.

Economists generally agree with Lowe’s neutral rate assumption, although there is a bias among forecasts for the RBA to stop at 2.25% in 2023. As to how the board gets there – in terms of timing and magnitude of hikes in the months ahead – there are many possible combinations and permutations, and about as many individual economist expectations.

What we do know is the RBA is now focused on the need to “normalise” rates (ie get to “neutral”). Whether this involves a series of consecutive 25 point hikes, or 40 in June, or more outsized hikes but at fewer meetings, or even hikes in between meetings, it matters not. Barring any significant change in macro settings ahead (Putin’s assignation and Russia’s surrender, a President Xi about-face on zero-covid, or even a cure for covid…all nice dreams) the RBA has begun a hiking cycle and yesterday was only the beginning.

That’s not to say the RBA is not well aware of the potential consequences. One reason US economists are not screaming “recession ahead!” now the Fed has become very hawkish is because US household balance sheets are on average in a healthy position. In Australia, household debt is at record levels.

The RBA will not mind if house prices cease their parabolic increases and finally pull back to more affordable levels, but will mind if a house price collapse is triggered by mortgage foreclosures. A whole generation of Australians has never experienced a rate hike cycle. Arguably, many a recent young(ish) new home owner is ignorant to the consequences, having felt confident enough to take out overbearing mortgages with a cash rate at 0.10%.

The impact will need to be monitored closely by the RBA, and it is not beyond the realms the board goes hard to start with, and then pauses to assess the collateral damage. Or, as some economists suggest, the board does not go too hard to begin with so as to make the transition more manageable.

As noted, there are many combinations and permutations, with macro developments still very much in the realms of uncertainty.

Could Australia go into recession?

Recent Australian history shows rate hike cycles don’t have to cause recessions and recessions don’t have to be preceded by rate hike cycles.

The last rate hike cycle began in 2010, as rates began to normalise globally following the then “emergency rates” put in place in the GFC. Australia did not subsequently go into recession. The prior cycle began in 2002 and ran steadily up to the GFC, including the much referenced 2007 hike just ahead of the election – being the last time the RBA has done so – but given Australia saw only one quarter of negative growth, it did not technically suffer a recession.

The last recession was in 2020, but it was one out of the box. The RBA was actually in a cutting cycle before covid hit. The last non-left field recession was in the early 90s, following a decade of ultra-high inflation and cash rates, and the 1987 stock market crash. Rates came screaming back down again from 1990 during the “recession we had to have”.

While the US might fear recession if Fed policy proves to overcompensate for being “behind the curve” for a year or more, the US economy did contract by -1.4% (running annualised rate) in the March quarter. Our March quarter number will be out in June, but the RBA is forecasting a well above-trend 4.25% growth rate over 2022, falling back to 2.0% in 2023.

Not the stuff recessions are made of.

Bank Response

Following the surprise 25 point RBA rate hike, the Big Four banks have decided not to re-price their variable mortgage rates. By “re-price” I mean that while they have all now increased their variable mortgage/investment loan rates by the full 25 points, they have not gone any further.

Economists did not expect they would. Aside from a highly competitive market – not just amongst themselves but in a market now full of fintech “disruptors” – the banks had not been waiting around for the RBA to make its move. Interest rate markets have been shifting rates higher for some time now, forcing the banks to begin increasing their loan rates before now.

And while higher rates imply higher bank margins – deposit rates will also rise but shy of loan rate increases – the balancing act must include consideration of a resultant increase in mortgage defaults, and bad debts in general.

On Monday, talk of a rate rise coming this week despite the election was one reason the Australian stock market tanked, including the banks. They were a little lower yesterday too. But today, with uncertainty removed, the financial sector is up 0.8% at the time of writing.

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