Interest Rate Uncertainty: Deciphering What RBA Cares About in Inflation

Amidst a global surge in inflation, Australia has seen a series of interest rate hikes since April 2022, a strategic move by the Reserve Bank of Australia (RBA) to counteract these inflationary pressures. These increases, a departure from the record-low rates we've grown accustomed to, have rippled through the economy, affecting everything from mortgage repayments to business loans.

It's a complex scenario, and pinpointing when this upward trend might reverse is no straightforward task. However, the RBA's decisions are not made in a vacuum; they're carefully calibrated responses to a range of economic indicators and global trends. In this piece, we delve into the key factors the central bank monitors, providing a clearer lens through which to view future policy shifts, even if the exact timing of a rate decrease remains an open question.

Australia's current economic landscape, particularly in terms of inflation and monetary policy, is navigating through a phase of transformation. Since November, the Reserve Bank of Australia (RBA) has increased interest rates by 25 basis points, marking a strategic shift from the previous period of steadiness. This decision reflects the RBA's response to the unexpectedly resilient economic activity and inflation rates. Although inflation is gradually declining, it's projected to return to the target rate more slowly than initially anticipated.

According to Michele Bullock, chair of the Reserve Bank Board of Australia, a key aspect of this inflationary phase is its domestic and demand-driven nature, contrasting with the earlier supply-side disruptions caused by global events and supply chain challenges during the pandemic. The broad-based nature of inflation, extending beyond just fuel, electricity, and rents to a wide array of goods and services, underscores the depth of these demand-driven pressures.

The RBA's analysis indicates that strong domestic demand is a significant factor driving inflation, especially evident in the service sector, where costs are rising sharply. This situation is further compounded by increased labor and non-labor costs, signaling persistent domestic cost pressures. The high rates of labor utilization point to limited spare capacity in the economy, suggesting that demand continues to exceed supply.

Diverse forecasts from top financial institutions provide key insights into the RBA's potential interest rate decisions.

OECD (Organization for Economic Co-operation and Development) assumes that the cash rate will be held at this restrictive level until inflation is clearly declining to the target band, with 75 basis points of interest rate cuts assumed between the third quarter of 2024 and end-2025.

National Australia Bank foresees the RBA cash rate peaking at 4.60% by March-2024, maintaining this level until the first cut happens by the fourth quarter, eventually leading to a rate of 3.10% by March 2026.

Westpac anticipates a deceleration in inflation and the labour market in Q4 and beyond, and so continues to expect the cash rate will remain at its current level until Q3 2024, when the next rate cutting cycle begins.

Bringing inflation back to its target, therefore, is not just a matter of adjusting interest rates; it requires a careful balancing act to align aggregate demand with supply. The RBA anticipates this process to extend over the next two years, underscoring the complexity of moderating inflation while supporting employment growth.

"It took only three quarters to fall from 8% to 5.5% as the supply side issues eased and there's still a bit more to go there, but we expect it's going to take another two yeas for inflation to fall that much again and move below 3%." Governor Bullock said in her speech during the Australian Business Economists annual dinner.

In conclusion, the RBA will continue to closely monitor economic indicators, particularly inflation and labor market conditions, and adjust interest rates accordingly. Given the current context of inflation being more domestically driven and demand-based, the RBA may consider further interest rate adjustments to ensure that inflation returns to its target range.

Source: RBA, OECD, NAB, Westpac