The Reserve Bank of Australia has lifted rates to the highest level since 2011. Is a soft landing still possible for the Australian economy? 

    At its 7 November meeting, the Reserve Bank of Australia (RBA) board increased the cash rate target by 25 basis points (bp). It was the first rate rise since June 2023 and the first under new governor Michele Bullock GAICD. It was also the 13th hike of the current cycle, taking cumulative tightening since May 2022 to 425bp and the cash rate to its highest level since 2011.

    Surprise CPI

    The September 2023 version of this column — written halfway through the RBA’s four-meeting- long pause — had reported growing market speculation that Martin Place might be done with rate hikes. It said that if that proved to be the case, Australia looked to be en route to a possible soft landing. So, what happened? And is a soft landing still possible? September’s column did caution that a still unpredictable international environment and the threat of persistently strong services inflation could interfere with that possibility.

    In the event, both had a role in triggering the RBA’s November rate hike via their contributions to a higher-than-expected September quarter Consumer Price Inflation (CPI) result that was the immediate driver of the November policy shift.

    First, a Riyadh-Moscow agreement to scale back oil production drove a near 30 per cent increase in oil prices between the end of June and the start of October. The bond market rout of early October then saw oil prices fall back, before the 7 October attack by Hamas on Israel prompted a second, smaller spike. This second increase proved short-lived and soft global demand meant that at the time of writing, oil prices had retreated again. But before then, that first run of higher prices saw automotive fuel prices rise 7.2 per cent over the September quarter — the series’ highest quarterly rise since Q1:2022 — contributing about 0.3 percentage points to the quarterly CPI increase.

    Partly as a result, the quarterly rate of goods price inflation accelerated from 0.9 to 1.2 per cent. In annual terms, goods inflation did ease, dropping from 5.8 per cent in Q2:2023 to 4.9 per cent in Q3:2023. But higher fuel prices meant that decline was smaller than anticipated.

    What to expect

    More significantly, the quarterly rate of services inflation rose from 0.9 per cent in Q2 to one per cent in Q3. A range of persistently strong services price increases drove this outcome, with rents a key contributor. The largest increase in Commonwealth Rent Assistance in 30 years shaved 0.3 percentage points from rental inflation and abated the 2.2 per cent rents hike.

    As a result, the annual rate of services inflation remained elevated, only slowing from 6.3 per cent to 5.8 per cent. Granted, both headline and underlying rates of CPI inflation fell for a third consecutive quarter. The former eased from six per cent in Q2 to 5.4 per cent in Q3, and the latter — as measured by the trimmed mean — slowed from 5.9 per cent to 5.2 per cent. But both exceeded market expectations, which had predicted 5.3 per cent and five per cent outcomes, respectively. More importantly, both looked high relative to the inflation trajectory implied by the forecasts in the RBA’s August 2023 Statement on Monetary Policy (SoMP): a headline inflation rate of 4.25 per cent and a trimmed mean rate of four per cent by year end.

    Credibility matters

    Indeed, when the RBA later updated its forecasts in the November 2023 SoMP to incorporate the new data, it predicted a more gradual disinflation, with both headline and underlying inflation now expected to end 2023 at 4.5 per cent.

    While the August SoMP had headline and underlying inflation back inside the target band at 2.75 per cent by the end of 2025, the November SoMP still saw both rates ending at the top of the band at three per cent. Those changes to actual and expected inflation matter for inflation expectations and for RBA credibility. Expectations play a key role in the way that central banks think about inflation. Theoretically, future inflation expectations are an important driver of current inflation because they influence households’ spending decisions, workers’ wage demands and firms’ pricing behaviour. If households, workers and firms expect inflation to be high, they will adjust spending, demand higher wages and charge higher prices, producing self- fulfilling inflationary outcomes.

    The latest IMF World Economic Outlook cites research finding that in the past two years, inflation has been driven increasingly by near-term expectations, such that for the average advanced economy, expectations now represent the primary driver of inflation dynamics. On their estimates, inflation in advanced economies rises by about 0.8 percentage points for each one percentage point rise in near-term expectations.

    Credibility is important because it is one of the critical ways policymakers influence expectations. If a central bank’s commitment to its inflation target is credible — in the sense that economic agents collectively trust that it will wield monetary policy to ensure that inflation returns to target over time — then inflationary expectations will become “anchored” around that inflation target.

    No hesitation

    From the RBA’s perspective, the Q3:2023 CPI outcome threatened to de-anchor inflationary expectations and undermine credibility. Higher- than-expected inflation implied that it would now take longer for inflation to return to target. Higher- for-longer inflation risked a direct increase in inflation expectations, plus a hit to RBA credibility.

    Bullock had used her first speech as governor to warn that the RBA board would not hesitate to raise rates if inflation was set to increase relative to the RBA’s August 2023 forecasts. That was on 24 October. On 25 October, the Q3:2023 CPI data was published. Given that timing, leaving rates unchanged would have been difficult.

    What does this imply for the chances of a soft landing? It’s still possible. One 25bp move is unlikely to guarantee a recession, especially when the unemployment rate still has a three in front of it. But a cumulative 425bp of rate hikes is a significant load for the economy and each increase from here does materially increase recession risk. Directors agree, according to the latest AICD Director Sentiment Index (October). Over half the respondents thought increasing interest rates at the current rate would cause a recession. 

    This article first appeared under the headline 'Higher For Longer’ in the December 2023 / January 2024 issue of Company Director magazine.  

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