MNI: Rate To Plateau, Despite Strong Inflation - Ex-RBA Staff

The Reserve Bank of Australia is only likely to hike the cash rate further should price rises fall outside its expectations, ex-staffers told MNI, though they cautioned that the weakness of the local dollar has tempered the effectiveness of monetary policy in containing inflation.

Jonathan Kearns, former head of the RBA’s financial stability department and now chief economist at Challenger, believes monetary policy should be tighter, but slow wage growth means the Reserve would not need to raise rates as high as other countries. The cash rate could plateau for some time as goods inflation falls and despite weak productivity tending to drive services prices higher.

The RBA held pat for the second month running on Aug. 1, noting it needed more time to evaluate macro-economic data. (See MNI RBA WATCH: RBA Pauses With Tightening Bias) The decision followed a 1pp drop in quarterly headline inflation to 6% over Q2, despite an over 20-year high services inflation print at 6.3%.

"My guess is that we can then bring inflation down relatively easily from 6%, but that means the RBA will need to hold rates relatively high to get the last bit of inflation out of the system," Kearns argued.

The RBA updated its forecasts last week, slightly downgrading GDP estimates, but keeping estimates for inflation and unemployment.

CALLS TO RAISE

Peter Tulip, chief economist at the Centre for Independent Studies and a former senior research manager at the RBA, called on the Reserve to raise the cash rate to cool overheated labour and housing markets, and added that the weak Australian dollar, among other factors, had softened the effectiveness of the cumulative 400bp of interest rate hikes since May 2022.

The Australian currency was the worst performing in the G10 over the last month, with a recent ING report noting AUD/USD was about 18% undervalued (see chart).

“The exchange rate channel isn’t reducing inflation like it normally would and we can tell similar stories in a lot of other channels of transmission with monetary policy, where an increase in rates would reduce demand and inflation,” he noted. “The economy is still reacting to the pandemic – we're still in the aftermath of that and it is throwing a lot of usual relationships off.”

He added, while these relationships have shifted, higher rates could still bring down inflation and the RBA should not pause at 4.1% at future meetings. He called on the Reserve to lift the rate to 4.8%, a level the bank had debated internally, according to freedom of information-released communications published in May.

MNI has reported on the breakdown of several factors driving inflation, many of which are outside the immediate influence of monetary policy, such as rent and market services inflation.

Tulip noted that while prices were resilient in some areas, high enough rates would eventually broadly slow the economy without endangering the RBA's "soft-landing".

“The economy is severely overheated, particularly in the labour and housing markets, and my sense is they are the biggest risk to future stability," he argued. "If we can take some of the heat out of these markets and bring them to more stable and sustainable positions, then the economy in the medium run will be more stable."

Despite calling for higher rates, Tulip noted the RBA board will likely pause in Sept. "It will likely not change rates until it gets surprising inflation numbers and my guess is that surprise will likely fall more on the high side than on the low side."

Kearns agreed the RBA would choose to pause in Sept. as long as trimmed-mean inflation and other data points remained within expectations.

The RBA board will next meet Sept 5.