MNI POLICY: Investors Systematically Underestimating RBA

Markets and macroeconomists are consistently underplaying the potential for higher Australian interest rates, creating a disconnect with what the Reserve Bank of Australia sees as its consistent communication of its determination to achieve its inflation target, MNI understands.

While some economists blamed the RBA for investors’ surprise when it hiked the cash rate by 25bp to 3.85% at its May 2 meeting, the Reserve considers that its February forecast for rates to rise had made its intentions clear. In fact the market initially priced in a May hike, but moved lower as investors bet the risk of pushing unemployment higher would stay the RBA’s hand. (See MNI RBA WATCH: Shifts Hawkish, Targets Services)

A similar divergence is developing ahead of the RBA’s June 6 meeting, for which overnight index swaps price in a pause, with a slight chance of a hike in July. Yet the RBA’s May minutes released on Tuesday show its commitment to reducing inflation to its 2-3% target and noted that its one-meeting pause in April was intended to allow it to confirm the economy was tracking as expected after earlier aggressive hikes.

In previous hiking cycles, the Reserve has paused some months and hiked in others (see chart below) and this tightening period is unlikely to be different, MNI understands.

WRONG BET

Macroeconomists admitted to several factors behind their poor performance picking the May hike. Australia has a small community of economists and echo chambers form easily, while some believed the RBA would not dare risk recession.

Callam Pickering, APAC senior economist at employment website Indeed.com and former senior analyst at the RBA, agreed the Reserve typically pauses during rate moves – up or down – to gauge the impact, but breaks usually last longer than a month.

“This happened a little faster than people anticipated,” he said. “There had also been some data which suggested inflation was starting to move in the right direction and there was a feeling that perhaps the RBA would be okay with just letting this go for a couple of months to monitor it.”

Market economists do not typically misread the RBA’s intentions, Pickering noted.

“It's usually pretty clear what they want to do and the timeline under which they want to do it and those who have followed the RBA for a long time or been involved in macroeconomics can usually get a good sense of what it is thinking,” he continued. “That clearly wasn't the case with this latest meeting, which suggests the RBA’s communication was perhaps a little lacking. It could also be that economists are reading the economy very differently from the RBA right now, which might mean we are right or they are.”

The Federal Government's RBA Review, which published recommendations last month, proposed greater transparency and increased access to policymakers. (See MNI BRIEF: RBA Review Targets Less Meetings, More Transparency) A recent RBA research paper, however, noted financial markets appear to systematically misunderstand how the Bank responds to data, highlighting the importance of clear communication.

Mariano Kulish, University of Sydney professor and a former RBA senior manager, said the persistence of inflation had caught the central bank and economic community off-guard and expectations were still catching up with reality. He argued April’s pause lulled some into the false belief that inflation had peaked and the RBA’s work was done.

“The question now is one of magnitude and timing,” he explained. “The previous forecast had inflation back in the target band by 2025 and that was maybe too long, running the risk of inflation expectations starting to drift up.”

He noted the forecasts suggested monetary tightening executed to date and the gradual removal of fiscal stimulus measures might be enough to return inflation to target, but this would be data dependent and more hikes may be required.

“The U.S. Treasury yield curve suggests the U.S. Federal Reserve will reverse course within two years,” he added. “I feel confident that might happen, but whether over the next two years that requires more or less adjustments to policy both in Australia and the U.S. is to be seen.”