MNI: Over-Optimistic RBA To Be Forced To Hike More-Ex Staffers

The Reserve Bank of Australia will be forced to hike rates to 4% or higher and then hold them for a substantial period to reduce inflation to target, despite its insistence on seeing evidence of excessive wage growth before further tightening and Governor Philip Lowe’s caution over financial stability risks, former senior RBA officials told MNI.

While the RBA toned down its guidance to indicate that “further tightening may well be needed”, as opposed to the former “will be needed”, after it left the cash rate on hold at 3.6% at its meeting on April 4 (see: MNI RBA WATCH: Rates on Hold, Bank Charts Cautious Path), its view that inflation will fall back to the top of its 2-3% target range by mid-2025 is excessively optimistic and it will be forced to hike again, the former officials said.

Warwick McKibben, Australian National University economics professor and former RBA board member, said the Bank missed an opportunity to hike a further 25bp in April.

“The RBA should focus on what interest rates should be, not how much they need to change,” he noted. “Otherwise, they will always be playing catch up. The neutral rate should be somewhere between 4-4.5% and closer to 5% for tightening.”

FINANCIAL STABILITY

Governor Lowe, who earlier in his career spent time at the Bank for International Settlements and was appointed chair of the BIS’s Committee on the Global Financial System in June 2018, places too much weight on fears that rapid rate rises will undermine financial stability, a concern only magnified by March’s collapse of Silicon Valley Bank in the U.S. and the enforced takeover of Credit Suisse, McKibben believes.

“[Lowe] is very sensitive to financial stability and you can see that behind the reason rates did not drop fast enough from about 2014,” McKibben said. “[The RBA] was worried about pumping up asset prices in Australia. Now, flip that upside down – the Reserve is concerned about raising rates too quickly, which will increase financial instability.”

The RBA may also be exhibiting too much patience with regards to wages, though it will try to avoid a recession at all costs, said Jonathan Kearns, former head of the RBA’s financial stability department and now chief economist at Challenger. While Lowe has said the Reserve was prepared to take slightly longer to return inflation to target than other central banks in order to preserve employment gains, Kearns noted that the wage price index will be a lagging indicator as employees facing high inflation until 2025 seek pay increases.

“I suspect we will see stronger wage growth and more inflation baked into the system, and therefore we will end up needing to hold those policy rates higher for longer to try to get inflation down,” he argued.

MARKET MISPRICING

Peter Tulip, chief economist at the Centre for Independent Studies and former senior research manager at the RBA, agreed the Reserve will likely need to hike above 4%. Overnight index swap markets, in contrast, imply the cash rate has already peaked, with a potential 25bp cut priced by the end of 2023.

Markets are taking RBA statements and forecasts at face value, Tulip said.

“I don't think the RBA’s forecasts are credible and, in particular, I think the Reserve’s view inflation falls back to 3% by mid-2025 seems very optimistic,” he said. “It is possible, but everything needs to go right and nothing can go wrong. There's pressure on rents, electricity, wages and on inflation expectations and for inflation to fall we must assume it occurs despite those pressures.”

McKibben agreed markets are mispricing future RBA hikes.

“Rates will likely go higher, but anything could happen in the world economy right now,” he said. “But with current inflation at 6.8%, a depreciating Aussie dollar and import prices a major source of the inflationary shock, the Bank will have to start raising interest rates to get the Australian economy back into some sort of equilibrium.”