15 August 2022

The RBA should pivot soon to deliver a soft landing

If the RBA wants to deliver a soft landing and avoid a recession next year, slowing down the pace of its hiking soon makes sense.

As is now evident, even to the Reserve Bank of Australia (RBA), it would have been helpful to have started lifting interest rates earlier. As the Governor, Phil Lowe has said, the forecast miss on inflation was ‘embarrassing’. The sharp and surprising rise in inflation has seen the RBA play catch-up by delivering a very rapid set of interest rate hikes.

Of course, the RBA is not alone, as many other central banks have been doing the same, including the US Federal Reserve. In Australia’s case, the RBA has lifted its cash rate by 1.75% in over just 90 days, including three super-sized 0.50% moves. Households may have some form of ‘whiplash’ from the shift, given that only in late 2021 the RBA was stating that it did not expect to be lifting rates until 2024.

The aim now is to get annual inflation to head back from the RBA’s forecast peak of nearly 8% later this year, to the RBA’s 2-3% target band over time, without pushing the economy into a recession. The pathway for doing this is a narrow one, as the RBA has admitted. However, the RBA may still have a better chance of delivering a soft landing than some other countries.

A key reason for this is that although inflation has picked up sharply, it has yet to feed into inflation expectations. Households, businesses and bond markets are still saying that their medium-term expectation is that inflation will be in the RBA’s 2-3% target band.

These low medium-term inflation expectations are also still embedded in national wage settings. In particular, although there has been some pick-up in wages, the upswing in wages growth is not yet broad-based across the economy.

A long period of low inflation before the pandemic has been somewhat embedded in the wage setting system. With around two-fifths of wages set using enterprise bargaining agreements, and these typically being 2-3 years long, wages growth has been slow to rise above the embedded rates of 2-2.5%. Although this means the sharp rise in inflation is lowering households’ real spending power, it may also mean the RBA does not have to lift interest rates as much.

Another factor that may help the RBA is timing. Australia’s inflation outbreak has come later in the global inflationary cycle, just as there are signs that global inflation may have peaked. Global shipping costs are easing and many supply chain indicators suggest they are starting to become less clogged. Commodity prices appear to have peaked, with oil, metals and agriculture prices falling recently. In addition, global growth is slowing, which could further ease global inflationary pressures.

Finally, let’s not forget that the RBA also has a very powerful policy tool, in the form of its cash rate moves. With 60% of mortgages at variable rates, its cash rate hikes feed through to households rapidly and are already cooling the housing market and sharply weakening consumer sentiment.

However, for the RBA, a key challenge is knowing how much tightening will be enough. In the previous episode of monetary tightening in the early 2000s, the RBA took a gradualist approach. It was able to lift the cash rate a bit and then wait and see the impact on the economy, with the option to come back and tighten more later, if needed. This time, the fact that RBA did not see the inflation spike coming has meant the need to tighten very quickly.

As a result, it is not possible to see the full effect of these interest rate rises on the economy yet. Economic statistics are published with a lag and monetary policy takes time to affect the economy. Most standard models suggest the full effect of the recent hikes won't be in the actual data until later this year, at the earliest, and will mostly come through in 2023.

The RBA has to rely on its models and forecasts to work out how much tightening will be enough to get inflation to come down, but not deliver a recession. A challenge indeed, given how reliable the models were in seeing the inflation outbreak in the first place.

The guidance from the RBA is that its models suggest that a cash rate of around 2.5% is ‘neutral’. That is the level of cash rate at which monetary policy neither supports nor weakens growth. And that the RBA is set to lift the cash rate to at least around this level.

With the cash rate already at 1.85%, the RBA is nearing that level. While clearly the RBA needs to bring down inflation, if it tightens too far and delivers a recession in the process, this too, could be ‘embarrassing’.

Paul Bloxham is HSBC’s Chief Economist for Australia, New Zealand and Global Commodities