We confirm our view that the cash rate will increase by 50 basis points next week – global interest rates have risen further and the cash rate is still below the RBA’s estimate of neutral.
The Reserve Bank Board meets next week on October 4.
We expect it will decide to raise the cash rate by a further 50bps to 2.85%. Readers will be aware that on September 19 we changed our forecast for the October meeting from a 25bp increase to a 50bp increase.
Global interest rates have lifted significantly since the last Board meeting on September 6 and the speech to the Australian Business Economists on September 8.
Westpac has raised its forecast for the terminal federal funds rate from 3.375% to 4.625% (up 125bps). This change occurred in the aftermath of the August inflation report for the US on September 14 (up 75bps) and the FOMC meeting on September 21 (up a further 50bps).
While we have argued strongly that the RBA Board should slow the pace of increases once it has reached a neutral setting there was always some uncertainty as to whether the current starting point for the meeting, 2.35%, was sufficiently close to neutral to justify the scale back.
The Governor and Deputy Governor have opined on several occasions that real neutral is at least zero and using long run measures of inflationary expectations as a guide to the nominal component (2.5%) then neutral is at least 2.5%.
Given this view and in light of the rise in global rates, it seems sensible to push the cash rate to 2.85% in October, taking it comfortably above the neutral benchmark before scaling back the pace of rate increases.
Note that the RBA Governor’s appearance before the House of Representatives Standing Committee on Economics on September 16 came after the US inflation print and the upgraded outlook for the federal funds rate and may be a more reliable guide to the Board’s inclinations.
At that inquiry, in our view, he appeared to be more hawkish than at the two earlier public events.
He emphasised his key challenge: “The general inflation psychology does appear to be shifting. It’s easier for firms to put their prices up, and the public is more accepting of this.”
He was more circumspect: “… at some point we’ll obviously not need to be increasing rates by 50bps at each meeting, and we’re getting closer to that point.”
And since the hearing we have seen another upgrade of the outlook for the federal funds rate by a further 50bps following the September FOMC meeting.
By lifting our forecast for the October meeting from 25 to 50bps we lifted our forecast for the RBA terminal rate by 25bps to 3.6% compared to a 125bp increase to our federal funds rate outlook to 4.625%.
Consequently, we now have the federal funds rate peaking 1.025% higher than the RBA peak.
The adjustment to the spread is taken in the currency and the margin between US and Australian long term bond rates. Relative to before the US inflation report we have revised down our end 2022 target rate for the AUD from USD0.73 to USD 0.65 – a US8c downward revision in the AUD.
We also revised down our target spread between AUD and USD long bonds from 40 basis points to 10 basis points.
The adjustments reflect the forecast widening of the terminal cash rate / federal funds rate spread by 100bp.
That widening results from our strong expectation that the RBA WILL slow the pace of the tightening at the November Board meeting to 25bps.
The Board will have responded to the sharp increase in the outlook for global rates; pushed the cash rate firmly into contractionary territory and slowed the pace to reflect its concerns about the lag to the impact on the economy of the accumulated rate hikes.
Rate hikes are expected to continue out to February 2023 as the December inflation report is likely to show consumer prices lifting strong in the December quarter, we expect a 2.5% jump in the headline and a still hefty 1.2% rise for underlying inflation.
If we are wrong and the terminal differential between the cash rate and the federal funds rate has to narrow by further than the 100 bp’s we now envisage, then it is likely to mean an extension of the RBA’s 25bp increases beyond February.