After hiking rates by a total of 125bps since May, the RBA will take a further step in "normalising monetary conditions" at today's August meeting (decision due at 2:30pm AEST). I expect the Board to hike its key rates by 50bps for the third meeting in succession, increasing the cash rate target to 1.85% and the Exchange Settlement rate to 1.75%. Likely upgrades to the inflation and labour market outlook in Friday's quarterly monetary policy statement could put a larger hike on the table today; however, with the wages growth data for Q2 yet to come in and with inflation expectations still anchored in the target band, market pricing indicates the current pace of tightening can be maintained.
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This preview looks at what I see as the three keys at today's meeting.
Outlook for inflation and the labour market
This is where the Board's reaction function appears to be, with Governor Lowe's last two decision statements noting the outlook for inflation and the labour market will be shaped by the incoming data and determine the "size and timing of future rate increases". The decision to accelerate the pace of tightening to a 50bps rate hike in June came after the RBA raised its forecast for inflation to peak at around 7% later this year from 5.9% in the May Statement on Monetary Policy.
Despite coming in below market estimates, last week's Q2 CPI report is likely to result in further upgrades to the RBA's inflation outlook, potentially revising the peak in Q4 to around 7.5% on headline CPI and around 5.5% for underlying (trimmed mean) CPI. As in June, that situation could prompt the Board to consider a larger rate hike today; however, the forecasts for 2023 and 2024 are arguably of more importance for policy. If the outlook from May remains broadly unchanged, with inflation forecast to slow sharply to a bit above 3% by the end of next year, then the Board may be content with the current pace of hiking.
Labour market conditions have outperformed the RBA's earlier forecasts, highlighted by an unemployment rate that has fallen further than expected to 3.5% in June. It has also been referencing the high levels of job vacancies as pointing to this strength being sustained. The missing element in the strong labour market remains wages growth, with the RBA having limited visibility (other than the insights from its liaison program) given the official data are published quarterly. Wages growth was running at a subdued 2.4%Y/Y in Q1 and the next update is not due until mid-August. The prevailing uncertainty leads me to think the RBA will not be materially altering its forecast for wages growth to peak at 3.7% in 2024.
Inflation Expectations
The importance of anchoring medium and longer-term measures of inflation expectations in the 2-3% target band was highlighted in the June minutes and in Governor Lowe's most recent speech. This current period of high inflation risked becoming more entrenched if the "inflation psychology" shifted and fed through to the wage-setting process. Given that Governor Lowe noted longer-term inflation expectations are anchored there doesn't appear to be any cause for alarm, suggesting that the current pace of tightening may be sufficient.
Neutral rate
In terms of where the RBA may be looking to take rates, the Board in the June minutes observed the cash rate was "well below" estimates of the neutral setting in Australia, indicating that further rate hikes were required to return inflation to the target band. Where exactly neutral sits is uncertain, but in his latest speech Governor Lowe said the RBA's research had tended to conclude the neutral rate "was at least positive".
If inflation expectations are anchored at the midpoint of the target band, Governor Lowe suggested that 2.5% could be a floor for the nominal cash rate this hiking cycle. On that basis, current market pricing points to the cash rate heading to a modestly contractionary range, peaking just above 3% in early 2023. The market profile points to 50bps hikes in August and September before the pace eases to 25bps hikes at each of the 3 remaining meetings in 2022.
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All in all, I expect the Board to hike rates by 50bps for the third meeting in succession. Likely upgrades to the outlook for inflation and the labour market in Friday's quarterly statement means the prospect of a larger hike of 75bps cannot be completely ruled out but in the absence of key wages data, with longer-term inflation expectations anchored between 2-3% and not under pressure from market pricing to become more aggressive, maintaining the current pace of tightening looks the more likely outcome.
