• The RBA Board today announced that it would increase the cash rate target by 25 basis points to 0.35%.
  • The RBA also announced that it does not plan to reinvest the proceeds of maturing government bonds and it expects the Bank's balance sheet to decline "significantly". This decision was expected.
  • The RBA has made a massive upward revision to their inflation forecast profile, which indicates they are likely to take monetary policy to a contractionary setting.
  • We have revised our profile for the cash rate and now expect further 25 basis point rate hikes in June, July, August and November 2022 that would see the cash rate target end the year at 1.35%. We then expect a further 25 basis point rate hike in February 2023 that would see the cash rate target at 1.60%. From there we have the key policy rate on hold over 2023.

The decision

The RBA Board today announced an increase in the cash rate target for the first time since November 2010. The cash rate target was increased by 25bp to 0.35%. The size of the move blindsided economists and financial market participants. More specifically, there was nobody across the sell side of economists that expected a 25bp increase in the cash rate today. The consensus call was for a 1Sbp increase to take the cash rate target to 0.25%.

Regular readers will know that since February 2022 we had expected the RBA to commence normalising the cash rate in June 2022. We did note, however, that we thought it would be a close call between an 'on hold' decision and a rate hike today (we had ascribed a 60% chance to on hold, a 30% chance to a 1Sbp increase in the cash rate and a 10% chance to a 40bp increase in the cash rate).

We stuck with our call for a first rate hike in June heading into today's meeting because we took the April 2022 Board Minutes at face value. Recall that in the April Minutes the Board stated that data over coming months on both inflation and the evolution of labour costs would underpin their policy deliberations on the cash rate.

Today's decision means the RBA walked away from their April guidance that data over coming months (emphasis on plural) would inform their decision on the cash rate. Rather than wait for official data on the evolution of labour costs (i.e. the 01 22 wage price index, due 18 May; and the 01 22 national accounts, due 1 June), the Governor has instead today cited the RBA's "business liaison" and "business surveys" to make the case that wages growth is moving sufficiently higher.

The business surveys had for some time indicated that wages growth was moving higher, so it was a surprise that the Board only today decided to put weight on "unofficial" wages data.

Reading between the lines, the RBA has simply been caught off guard by the strength of the 01 22 CPI data (note, in his post­ statement conference the Governor described the 01 22 CPI data as 'a shock'). As such, the Board decided that it could no longer afford to wait to raise the cash rate. In the grand scheme of things waiting one more month to raise the cash rate would not have changed the economic outlook. But clearly the inflation data last week put the RBA in an uncomfortable place, which is why they delivered a rate hike today.

The RBA have massively upwardly revised their forecast profile for both headline and underlying inflation. The RBA now expect underlying inflation of 'around' 4¾% in 2022. Their previous forecast from the February Statement on Monetary Policy was underlying inflation of 2¾% in 2022. A 200bp increase in their inflation profile over 2022 is a radical revision. Indeed it indicates the RBA has completely changed their view on the outlook for inflation. The RBA appear like inflation fighters now, much like many of their other central bank counterparts.

We are disappointed in some aspects of the RBA's communication today. Having stressed the importance of the need to conclude that inflation is 'sustainably within the target range' before raising the cash rate for the past few years, the word sustainable didn't appear once in the Governor's Statement today.

The RBA also announced that it does not plan to reinvest the proceeds of maturing government bonds and it expects the Bank's balance sheet to decline "significantly, as expected.

The mechanics of the cash rate target

My colleague Philip Brown, Senior Fixed Income Strategist, notes the wholesale cash system now is very different to what it used to because of the RBA's recent history of Quantitative Easing. There is far more cash in the system. The new structure of the wholesale cash system has meant the RBA has had to acknowledge this new reality and set a very unusual cash rate target of 0.35%. However, because of all the excess cash in the wholesale system it seems very unlikely the actual cash rate will be 0.35%. It seems more likely the actual cash rate will sit somewhere between 0.25% (the rate now paid by the RBA on Exchange Settlement balances) and 0.35% (the cash rate target).

Before the pandemic, when cash in the system was scarce, the RBA could target the actual cash rate very closely, but now there is much more excess cash, the RBA will likely need to accept achieving an actual cash rate within a target range. This is a marked departure from historical experience in Australia, but is the standard operating procedure of the US Federal Reserve - and for similar reasons.  For the moment the actual cash rate will likely be very close to the lower bound (the ES rate), but over time it may range more widely inside the band.

The outlook

The RBA's radical upward revision to their inflation forecasts points to a swift and slightly more aggressive tightening cycle than we had previously anticipated. As such we have made a revision today to our forecast profile for the cash rate target.

We now expect further 25bp increases in the cash rate in June, July, August and November 2022 that would see the cash rate target end the year at 1.35%. We expect a further 25bp rate hike in February 2023 that would put the cash rate at 1.60%. This is 35bp above our previous call that the RBA would take the cash rate to 1.25% in early 2023. From that point we have the policy rate on hold over 2023.

Our estimate of the neutral cash rate remains at just 1.25%, so our updated forecast means that we now expect the RBA to take policy restrictive, but not materially so. The RBA still wants the Australian economy to remain strong and their aim is to see annual wages growth reset upwards to around ~3½% (well above the pre-pandemic norm of 2¼%). We believe they will achieve this outcome on the basis that the tightening cycle is not overly aggressive.

Here we note that our rates strategists believe there is a risk that the interest rate for the average standard variable loan rate could increase by a little more than the cash rate over the upcoming tightening cycle, given the cost of funds for lenders has increased.

The inflation data is red hot. But it is a lagging indicator and the RBA has only today increased the cash rate. Rate hikes will work to slow the rate of inflation and cool demand in the domestic economy, particularly over 2023. We have been on the hawkish side of the inflation narrative right through the pandemic due to the incredible fiscal expansion financed by money creation. But we do not believe that inflation will be a problem domestically over the medium term.

The Australian household sector is one of the most indebted in the world. This means that rate hikes have a more powerful impact on our household sector than they do in almost all other jurisdictions. And the policy transmission mechanism from the cash rate to home borrowers is much more direct in Australia than it is for many other central banks as the bulk of our debt is floating.

It will be particularly important from here to watch forward looking data, which includes consumer and business confidence, labour hiring intentions, credit growth, building approvals, capex expectations and home prices. If this data softens over coming months it will very much support our view that the RBA's tightening cycle will be shallow.