With underlying inflation rising through the top of the target band for the first time in 12 years and a labour market tightening more rapidly than forecast, the RBA looks likely to start moving its policy rate away from emergency settings with a 15bps hike today (decision due at 2:30pm AEST), as well as signalling the start of balance sheet reduction. Upward revisions to the RBA's inflation and wages growth forecasts are set to prompt a recalibration of the policy outlook with Australian growth prospects remaining robust.
This preview covers 3 key areas of focus for today's meeting.
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1. RBA to hike rates by 15bps
My call is for the RBA to start moving the cash rate target off its pandemic low of 0.1%. I think this first move will be a smaller hike of 15bps, bringing the cash rate target to 0.25%. Standard moves for the RBA occur in 25bps increments, while there are some calls for a 40bps hike today.
After the pandemic struck, the RBA cut rates by a total of 65bps through 2020, so a 15bps hike is a gradual start in reducing that emergency support. However, a gradual start could be a significant consideration given the RBA hasn't raised rates since November 2010. It may want to start hiking rates by a smaller amount than usual than to wait until June when markets could pressure the RBA into a larger 40bps hike.
Since November 2020, the cash rate target has been set at a 10bps spread over the rate on Exchange Settlement balances. The April meeting minutes indicated this arrangement would be retained for the time being, meaning that in the event the RBA elects to hike today, the rate on Exchange Settlement balances would likely rise from 0% to 0.15%. This would shift the range the actual cash rate trades at up from 0% to 0.1% to 0.15% to 0.25%.
The rise in inflation in Q1 to 5.1%Y/Y on a headline basis and to 3.7%Y/Y on the underlying rate reported last week prompted markets to bring forward their timing for the first hike from June to May, with a 15bps hike fully discounted today. The risk to a May hike call is that the RBA does not have an explicit tightening bias in place having emphasised the importance of waiting for the upcoming wages growth data (due 18 May); however, there were enough signs from the April meeting to indicate that a hike was close.
This included the hawkish tilt from the Board by removing its "patient" guidance for policy to respond to the evolving wage-price dynamics. The meeting minutes also identified the actions of other central banks in hiking rates to contain inflation as a key consideration for the RBA's reaction function. Having already started their hiking cycles, it is likely that later on in the week the Fed will accelerate the process by hiking by 50bps and the BoE by another 25bps.
Looking beyond today's decision, pricing in the swaps market sees the cash rate being hiked to at least 0.5% by July and to be at least 1% in 6 months' time. This week's updated economic forecasts (discussed below) will be influential to these expectations.
2. New economic forecasts to revise higher the inflation and wages growth outlook
Another important consideration behind a May hike is that the timing corresponds with an updated set of quarterly economic forecasts. Those forecasts will be released in full on Friday in the quarterly Statement on Monetary Policy, but they will be in front of the Board for today's decision and are often the catalyst for policy changes.
There should be some early insights in Governor Lowe's decision statement today, with the forecasts for inflation and wages growth key. Finalised back in February, the inflation forecasts were already in line to be revised materially on the back of the spillover effects from the Ukraine war on fuel and food prices. Q1's stronger-than-expected increases in Australia's key inflation rates mean those revisions will now be even higher than previously anticipated.
The current forecasts have headline inflation at 3.25% this year, moderating to 2.75% in 2023, while trimmed mean inflation is at 2.75% this year and next. Revisions that take trimmed mean inflation above the top of the target band north of 3% in 2022 and into 2023 would be an important development and could be used to justify a rate hike today.
A higher outlook for underlying inflation is likely to be supported by stronger wages growth due to the labour market tightening more rapidly than expected. The unemployment rate is at a 14-year low of 4% and the high level of job vacancies indicates further falls are likely. That could see unemployment fall even lower than earlier expected by the end of the year (3.75%) and in 2023 (3.75%).
While Australia is far from a wage-price spiral, a tighter labour market would put upward pressure on wages growth. That would likely see the forecasts for this year (2.75%) and next (3%) lifted. Wages growth of at least 3% in 2022 and higher in 2023 is broadly consistent with the sort of pace the RBA has said is needed for sustainable 2-3% inflation.
Whereas many central banks are having to cut their growth forecasts, the RBA is unlikely to alter its projections for 2022 (4.25%) and 2023 (2%) too significantly. A tight labour market, high accumulated savings and eased pandemic restrictions are supporting the consumption outlook, while there is also a very large pipeline of residential construction work. Headwinds are mostly coming from offshore, with global growth set to slow on the combined effects of the Ukraine war, China's lockdowns and monetary and fiscal tightening.
3. Balance sheet reduction to commence in July
Back in February, the RBA said it would defer to May a decision on the reinvestment of its maturing bond holdings. With the next maturity of Australian government bonds falling in July, a decision today gives markets advanced notice. Previously, the RBA has said the key factors in this decision will be the state of the economy and the outlook for unemployment and inflation.
Strong growth prospects and an upgraded outlook for unemployment and inflation mean the Board is likely to announce it will allow maturing bonds to start rolling off its balance sheet in July. However, it won't be until 2023 that the balance sheet really starts coming into focus as more of the bonds acquired in support of the 3-year yield target policy mature and as banks start repaying the 3-year funding drawn under the Term Funding Facility. A decision to start balance sheet reduction would put the RBA in sync with many of its central bank peers.
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A final point to note is that over the Covid period, the RBA has followed up decisions to change policy with post-meeting press conferences. If the RBA does hike today, expect Governor Lowe to front the press and analysts later on in the afternoon.