For the second meeting in a row the Reserve Bank of Australia’s Board has raised the cash rate by 50 basis points, putting the cash rate now at 1.85%.
We have had 1.75% of increases this year, the fastest pace in a generation. Despite this fast pace bond markets actually improved markedly on the day as the RBA left the door open for a slower pace of increases. Within 24 hours however, the realisation that the central banks is not stopping soon set in.
Markets being what they are, the fact the RBA would hike at a slower pace was interpreted to mean that the crisis was over and the new crisis will be a severe slowdown. In fact, the RBA made it very clear that the slower but steady pace of hikes might sustain much of the way through 2023. Currently, they expect next year’s inflation to be over 4%, well above their target of between 2 and 3%.
The willingness of traders to conclude that the RBA would cut rates while inflation is still at those levels implies that they actually expect the effect of what has already been done to shut the economy down significantly. The RBA has been communicating the exactly opposite view for the last few weeks.
So now is the question of who is the master of interest rates? The central bank burned an enormous amount of credibility in many eyes by stating that there would be no rate hikes at all until 2024. Credibility is a powerful tool when the task at hand is managing expectations. The market is ignoring the policy rate and focusing on the future.
The clear hiking trail in the RBA’s mind is confused and overgrown, perhaps needing to be backtracked and the Governor’s Statement even noted they are “not on a pre-set path”.
The offshore central banks are all ramping up their rate increase programmes and only last Thursday the Fed executed its second 0.75% rise in as many months. With no Fed meeting until September but lots of data to be released before then, the previously clear path is looking trickier there too.
Relief rallies in interest rates are also likely to spread to risk markets including equities and currencies. If the US unemployment data to be released on Friday 5 August reinforces the current fashionable view that a recession is inevitable and nearby the perverse effect on pricing could be positive give no need for the higher rates being priced in.
Surrounding all of this crystal ball gazing is the current fact of inflation being with us now, and likely to be above acceptable levels for at least several more months. It would go against every central banker’s grain to be reducing rates while inflation was still high. The RBA has said they think neutral rate settings might be in the middle of their inflation target range of 2-3%. This means we are still at stimulatory settings and there are at least 65 basis points of hikes to come before interest rates are effective inflation fighters. Getting excited about owning bonds potentially only halfway through a cycle seems “brave.”
Whether or not the estimation of the neutral rate is accurate is missing the point. The RBA put its credibility at risk with the no hike call. If they now reflect the market view and walk back from their belief that cash rates are not yet restrictive there is a chance they will lose any of the “moral suasion” we learned about in Ecos 1.01 and force them to resort to more direct action to achieve their policy goals.
The invasion of Ukraine by Russia is the first time since the end of the cold war that the developed world has felt the steel of true conflict. This propelled the monetary authorities to put their houses in order (as wars often have). Errors during unprecedented times; COVID, Ukraine, logistical hiccups and so on may be forgiven. Cutting rates while inflation – the primary villain in the monetarist world – remains high might not. The final word is from the final line in the RBA statement ”the Board confirms its commitment to doing what is necessary to ensure inflation in Australia returns to target over time.”
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