At its meeting just before the Melbourne Cup, the RBA Board decided to increase the cash rate target by 25 basis points to 2.85 per cent. They noted that inflation in Australia is “too high” and yet retained their moderation in the hiking cycle by only raising this amount where some market participants had been predicting a 50 basis point rise.
Notwithstanding the recent higher than expected CPI release and the RBA’s own expectations of inflation reaching an even higher 8% by year end 2022, they have decided to allow the impact of their earlier actions to reach effect rather than further “front loading” rate hikes. “The Board recognises that monetary policy operates with a lag and that the full effect of the increase in interest rates is yet to be felt in mortgage payments.”
Tuesday’s action shows that despite their statement “the size and timing of future interest rate increases will continue to be determined by the incoming data and the Board’s assessment of the outlook for inflation and the labour market”, it is difficult to envision what data outcome might be a catalyst given that the CPI surprise was not.
The key rationale for the RBA was that cash rates had been aggressively hiked and that unlike some other jurisdictions, these hikes will affect the real economy at lower yields because most borrowers pay a floating rate. In seeking to keep the economy on an “even keel” they are reflecting a mandate that is broader than simply getting the spot inflation rate to go down. As they state “The path to achieving this balance is a narrow one and it is clouded in uncertainty.”
The RBA also identified a path for inflation that keeps it outside their band for at least another year but much lower growth in 2023. In attempting to counter the interpretation that they are going soft on their CPI foe, they stressed their concern about the pace of wage growth overseas but were pleased that “Medium-term inflation expectations remain well anchored, and it is important that this remains the case.”
They also talked about the outlook for the global economy having weakened recently. The moderate growth and moderation of spending they are anticipating will be exacerbated by a fall off in world growth. The expectation for a material increase in unemployment from 3.5 to 4% indicates that they are going to need genuinely divergent data to bring bigger hikes back into play.
Bond markets have certainly taken a constructive view on the RBA approach. The market retains a positive yield curve and in the afternoon was at lower yields than before the announcement. Many other jurisdictions are bracing for their central banks to over tighten and cause a recession. This is not currently priced into the Australian curve. Despite the steady and potentially lower trajectory of rate hikes, AUS bonds are now at much higher yields than seen for many years. These higher yields bring their role as an asset class that is negatively correlated to risk assets in a growth shock back into play.
The RBA is signalling that the risk to the economy has now passed from rampant price adjustment to the inevitable outcome of lower demand and higher unemployment. Bond yields are responding to what the central bank is telling them (and perhaps deferring to their modelling expertise) by bringing yields lower. The positive Australian yield curve that implies rates will continue to rise well past the current expected terminal rate priced in, is providing an opportunity to add duration in a much more defensive allocation than when yields were artificially lowered.
If the RBA is right and the inflation impulse is destined to resolve, that growth for the next two years will be well below comfortable levels and that unemployment is set to materially adjust higher, investors will seek out rewards along the yield curve.
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