The RBA goes big on the cash rate to send a clear signal on inflation

The RBA’s decision to ‘go big’ with a 0.5 percent rate hike shows its desire to bring the rate up to as close to neutral settings as soon as possible. It shows that the RBA believes that inflation risks are firmly on the upside.

Going big has the advantage of clearly reinforcing the message that the central bank is looking to curtail inflation risk – especially that of allowing inflation to become embedded – by moving rates by a larger than average amount.

It also provides a response to those analysts who have suggested the RBA started increasing rates too slowly and has exposed Australia to higher inflation risk as a consequence. Today’s decisive action will go some, but not all, of the way to adjusting the market’s perception that the RBA has fallen behind the curve.

Even at 0.85 percent, comparable policy rates in other jurisdictions are still higher – UK 1 percent; US 1 percent; NZ 2 percent.

The reality however is that today’s lift in interest rates is likely to be one of several that will occur over the coming 12 to 18 months as the RBA seeks to normalise the interest rate environment in Australia after the recent period between November 2020 and up until last month when the cash rate was at an emergency setting of 0.1 percent.

KPMG notes the yield on 3-year Commonwealth Bonds, which has tended to align closely with the cash rate, started lifting in earnest in September 2021, while the RBA’s first move upwards in the cash rate was 7 months later. The market has just pushed the yield on 3-year Commonwealth Government bonds to 3.0 percent, which suggests – if the market is correct – that RBA Board has some serious catching up to do in terms of lifting the cash rate. KPMG’s view is that the RBA is likely to settle at a neutral rate around 2.5 percent, and this will occur sometime around the middle of next year; with the cash rate expected to reach around 1.75 percent – 2.00 percent by the end of this calendar year.

This gives the RBA some room to manoeuvre if those elements on the supply side start to diminish in terms of their importance in driving global inflation. Some indicators of this reduced influence include the softening of prices for semiconductors and falling shipping costs, while fertilizer prices in the US have fallen by a third from a peak at the end of March (albeit prices are still more than double pre-COVID levels). All of this, if it continues, should help ease global supply chain price pressures.

However, despite today’s large rate rise, it is also worth noting the RBA’s comments on the uncertainty of how households will respond to current conditions. This suggests that if household consumption growth slows more than expected the RBA will soften the pace of tightening.

The Board also noted that private sector wages growth is accelerating, with firms having to compete for staff in a tight labour market. The Fair Work Commission is set to increase the award wage by significantly more than the 2.5 percent rise awarded last year, and with other wage agreements also resetting over the next couple of months, aggregate wages growth is set to accelerate.

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