The Calm before the Storm
11 February 2025
The cash rate was left unchanged on Tuesday.
It’s been a bumpy ride over the last 6 months in terms of economic data according to RBA Governor Michele Bullock. The weight of data in the last half of 2023 and early 2024 suggested that the next change in the cash rate could be a cut. But more recent data has the market concerned over a possible rate rise or a return to a hawkish stance.
The RBA is happy with the current level of the cash rate and its 2025 and 2026 inflation forecasts remain unchanged. However, in the short-term, ongoing upside risks to inflation may slow the fall in inflation, and the RBA will not want it to slow too much.
“Inflation remains high and is falling more gradually than expected.”
“The economic outlook remains uncertain and recent data have demonstrated that the process of returning inflation to target is unlikely to be smooth.”
“The persistence of services inflation is a key uncertainty.”
“... there is a risk that household consumption picks up more slowly than expected, resulting in continued subdued output growth and a noticeable deterioration in the labour market.”
Statement by the Reserve Bank Board: Monetary Policy Decision, 7 May 2024.
https://www.rba.gov.au/media-releases/2024/mr-24-08.html
“Over the past six months we’ve seen quite a few ups and downs in the data. Things are pretty bumpy.”
“We believe rates are at the right levels … but there are risks, and at this stage the Board is not ruling anything in or out.”
“I think we still think things are reasonably balanced with perhaps a little bit of a signal that we need to be very watchful on the upside.”
“The inflation forecast in the next little while is going to be quite driven by petrol prices.”
The last half of 2023 saw inflation glide nicely down. Then in March, the RBA called a peak in wage growth and moved from a hawkish to a neutral stance. However, more recently, inflation for the March quarter fell less than the market expected, coincidentally mirroring the situation in the US. This upset the market’s narrative that rates were on their way down and raised fears that there could still be a rate increase or two this year - this can be seen in the upward movement of the yield curve compared to one month ago (see chart below).
At her press conference, Bullock reiterated that the RBA believes rates are at the right level, but she emphasised that the RBA remains vigilant and has increased its concerns around upward risks to inflation (given their potential impact). She points to petrol prices (which is of course volatile and exogenous) and services inflation, which remains high but the RBA believes has now peaked (see chart below).
While the RBA and the market pontificate over the upward risks to inflation, it is undeniable that the Australian economy is slowing. With its dual mandate of price stability and full employment, a slowing economy will be growing in importance in the calculations of the RBA. As evidence of the slowing, Bullock pointed to the recently released March quarter retail turnover volume which showed that retail turnover fell for the fifth time in six quarters on a quarterly basis (see chart below).
Central banks are more sensitive to inflation expectations than most commentators realise. Galloping inflation expectations is a central bank’s worst nightmare because it indicates that it has lost its monetary policy credibility. Such a loss in credibility requires big rate movements (Volcker-style) to get back. Not fun.
At the press conference following the Monetary Policy Statement, Bullock did mention inflation expectations and said that rising expectations was a clear case for a rate rise:
“But if we saw that inflation expectations were starting to shift and it was going to take markedly longer to come back to target we might have to be thinking about an interest rate rise.”
At the moment, public inflation expectations continue to trend down which is good (see chart below). However, 1-year consumer inflation expectations remain well above the RBA’s own inflation forecasts. If the final mile in reducing inflation is too bumpy with too many reversals, consumer inflation expectations could stop falling and become sticky. If that happens the RBA will likely be forced to raise rates.
With little change to the status quo, private debt investors can continue to enjoy high floating rates while the economy slows but remains in reasonable shape. A future rate increase would increase returns while a future rate cut would also be welcome as it would help with a slowing economy.