MNI POLICY: RBA Applies Judgement On Key Rates As Models Fail

Officials at the Reserve Bank of Australia are applying their own judgement to estimate the neutral levels of interest rates and unemployment as the hiking cycle reaches an inflection point, following the recent failures of their existing econometric models, MNI understands.

With inflation at 6.8% in April, the cash rate at 4.1% is currently well below the real neutral model average rate last estimated at about 1% in 2022. Prior to May 2022, when the Reserve's latest hiking cycle began, the RBA believed the nominal neutral rate to be about 2.5-3.5%, after it had gradually tracked lower from the pre-2007 5% level (see chart below).

Likewise, the non-accelerating inflation rate of unemployment would probably sit close to 6% according to current models, MNI understands, 200bp higher than the last time the RBA disclosed its estimate, and well above the actual unemployment figure recorded in April, when it fell to 3.6%.

However the RBA now regards its models as prone to a wide band of error after its failure to anticipate the post-Covid surge in inflation, and is trying to find replacements. While models are only a guide and never the determinant of rate-setting decisions, they are nonetheless important as monetary policy enters an inflection point, with their shortcomings leaving officials applying their own judgement to gauge when the tightening cycle is in danger of extending too far.

Other central banks have found themselves in similar situations, with the Bank of England applying a hard-to-quantify hawkish skew to its rate decisions after its models also underestimated inflation. (See MNI POLICY: BOE Hikes Whilst Seeking New Inflation Model)

The RBA’s previous neutral-rate methodology calculated a "real neutral rate" based on an average taken from nine different models from three different classes.

Higher-than-expected monthly CPI and strong wages growth against a backdrop of weak productivity drove the Board’s decision in early June to raise the cash rate 25bp, after April’s surprise unemployment print saw the overnight index swap market bring forward its estimate of further hikes. The market now expects the rate to peak at 4.43% by November.

The RBA’s models have been off the mark for a series of data points, including wages and house prices as well as inflation. (See MNI: House Price Strength Thwarts RBA Models)

APRIL PAUSE

It is in the context of this uncertainty that the RBA took its April decision to pause at 3.6%, which prompted criticism of its communications from some commentators.

Officials consider that, while the RBA intended to continue tightening policy, it needed more information to evaluate its position. It meets more regularly than other central banks in the developed world, and a pause was not historically out of character.

Similarly, its ability to raise rates each month together with the country’s reliance on variable home loans which means policy is transmitted more effectively to household cash flows, fed into its shift to 25bp moves from 50bp rises in September 2022.

The RBA will next meet on July 4.