Asset Allocation Strategy
13 November 2023
Sticky Inflation Forces RBA out of Step with Global Policy Peak
The RBA Goes Again

While a number of the world’s major central banks have hit the policy pause button in recent weeks (most notably the US Fed), the Reserve Bank of Australia (RBA) lifted rates 25 basis points (bps) to 4.35% last week.

Despite the run of “on hold” decisions globally (The Fed, European Central Bank, Bank of England, Reserve Bank of New Zealand, Bank of Canada), the hike was largely expected by the economist consensus. The futures market was also heavily tilted toward a hike, with a ~70% probability of a hike priced ahead of the decision.

Figure 1: Although this tightening cycle has been relatively swift by the RBA's historical standards, Australia's cash rate stands out as being low in a global context

The key reason the RBA cited for the hike was "the risk of inflation remaining higher for longer has increased." This makes sense when recent evidence is considered. As we have discussed recently, September quarter’s above-consensus reading for both headline and underlying inflation was materially above the RBA’s implied forecast. 

Importantly, the quarterly and monthly consumer price index (CPI) trend showed a reacceleration in inflation momentum. This is in contrast to the recent trends observed in both the US and Europe, where inflation is showing an encouraging deceleration on a quarterly basis.

Governor Bullock had recently stated that the RBA would not hesitate to raise the cash rate above 4.1% if there were a “material upward revision to the outlook for inflation”, reiterating the RBA’s “low tolerance” for a prolonged period of high inflation. Hence, it was not surprising that the RBA decided to hike in the wake of the September CPI numbers. The RBA had been on hold since their hike in early June. The cash rate has now been hiked by a cumulative 425 bps since May 2022.

Figure 2: The cash rate has now been hiked by a cumulative 425 bps this cycle

A Dovish Hike?

In its November statement, following the hike, the RBA stated a willingness to tighten further, if necessary, although there appeared to be a dovish shift in language in relation to the potential for further hikes. Specifically, the RBA said "whether further tightening of monetary policy is required to ensure that inflation returns to target in a reasonable timeframe will depend upon the data and the evolving assessment of risks". Previously, the statement was "some further tightening of monetary policy may be required". So, now the prospect of further hikes appears more balanced.


Is That It for RBA Rate Hikes?

The RBA’s reaction function from here will depend on the flow of economic data versus its current projections, most particularly in terms of inflation indicators (CPI and wages), as well as other indicators of the health of the economy, particularly the state of the labour market.

For the RBA cash rate outlook, Wilsons believe the current 4.35% cash rate is likely to represent the peak for the cycle, though the possibility of another hike early next year cannot be completely ruled out.

Current futures market pricing suggests a 20% probability of 1 more hike in early 2024. A hike in December looks highly unlikely, with early February more likely to be the crucial meeting (there is no January meeting). Wage growth statistics (WPI) for the September quarter and labour market employment figures are both due this week, but it would take a blow-out wages number to prompt the RBA to hike again in December.

Wage growth is likely to lift to 3.8% year-on-year (YoY), reflecting the sizeable mid-year lift in the award/minimum wage. Indeed, the RBA already forecasts the WPI in the fourth quarter of 2023 to lift to 4.1% YoY. Hence, the more likely timing for another potential hike remains February 2024, following the next quarterly CPI print. The CPI for the fourth quarter of 2023 (due January 31 2024) will determine whether the upside surprise in the third quarter has persisted. 

Figure 3: Underlying inflation is easing in year-on-year terms, but slowly
Figure 4: Wage growth data will be closely watched as further upside is expected in the two upcoming quarterly releases

The RBA does appear to have set a high bar for another hike, with upgraded inflation forecasts making it harder for inflation to surprise to the upside again, as it did following the September quarter release. The RBA has upgraded its fourth quarter 2024 headline CPI forecast to 3.5% YoY, from a previous estimate of 3.3%. The fourth quarter 2025 estimate was also pushed up to the top of the target band (3%) from 2.8%. As a result of this higher expected inflation profile, we see the RBA keeping interest rates on hold but 'higher-for-longer'. Our current rate view has the first cut currently pencilled in for very late in 2024.

The RBA has shown a willingness to ease policy before inflation has returned to the 2-3% target band, and we think the RBA will take this approach once again in the current cycle. The key triggers for a rate cut are likely to be inflation falling in the third quarter of 2024 to at least 3.5% YoY, combined with unemployment lifting towards ~4.5% (currently 3.6%). 


The Implications of Higher for Longer

The more stubborn inflation backdrop forced the RBA’s hand this past week, and while the RBA appears a reluctant hiker, a further hike cannot be ruled out if December quarter inflation fails to show some improvement. Even if November represents the peak for the domestic cash rate, stubborn inflation suggests the RBA will be very reluctant to ease policy within the next 12 months. This will likely have a number of implications.

While Australian equities and long-term bond yields will likely continue to take their directional cue from the (likely supportive) direction of global markets in coming months, current domestic inflation trends appear stickier than global trends. Australia’s higher-for-longer rate profile should “all things equal” support further gains in the AU$, as the interest differential with the US narrows. We expect the Fed to cut well ahead of the RBA. We continue with some partial hedging of global equity positions on this basis, with a view that the AU$ has upside back to marginally above ~70c.

With growth slowing and yields having adjusted up quite significantly, domestic fixed interest and floating rate credit (both public and private) offer a better risk-return tradeoff than domestic equities, in our view. 

An improving global inflation backdrop and our base case of no US or domestic hard landing keeps us relatively neutral on domestic equities. The domestic economy has weathered the rise in policy rates so far. However, the risk that the RBA inadvertently overtightens (via 1 or 2 more hikes) and sends the economy into a sharper than expected downturn is edging higher (this also increases the appeal of government bonds). Nonetheless, a domestic hard landing remains a “risk case,” not our central case.

Figure 5: Strong population growth is supporting economic growth but adding to inflation pressures
Figure 6: Cuts priced into the Fed Funds rate from mid 2024 imply a narrowing of the interest rate differential with the US and upside for the AU$

The domestic economy should continue to grow in 2024, albeit at a below-trend pace, aided by strong population growth which at the same time is contributing to Australia’s current sticky inflation problem. Indeed, migration appears to be tracking above recent Government projections, and in 2023 looks set to exceed 500k.

Indeed, we currently estimate population growth at ~2.5% YoY - the fastest growth in at least 50 years (and up further from 2.25% YoY in the first quarter of 2023). This is clearly making the RBA’s inflation battle more difficult.

Overall, we see a mixed outlook for the local share-market, with disinflationary global trends likely providing some upside pressure, while a higher-for-longer domestic cash rate will create headwinds for the local market. 

Within our neutral view on the Australian equity market (global equities still marginally preferred), investors should focus on active portfolio management, with the local market’s heavyweight banking sector particularly likely to struggle to grow in 2024.

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Written by

David Cassidy, Head of Investment Strategy

David is one of Australia’s leading investment strategists.

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