RBA: When the facts change, I change my mind. What do you do?

How did we get here — was this a policy mistake?

There are mounting expectations that the RBA will hike interest rates at the February meeting, including our own prediction on 16 December (chart 1).  Given this, some might argue that the RBA has made a policy error — failing to finish the job on inflation, cutting rates prematurely, and allowing price pressures to re‑ignite.  I don’t agree with this assessment. 

The RBA stuck fast to a deliberate strategy — to bring inflation down only gradually and avoid a larger increase in unemployment.  There were critics that were uncomfortable with this approach — preferring to go harder earlier or keep rates higher to drive inflation back to target sooner.

In my view, the RBA Board acted sensibly for several reasons:

• First, much of the inflation spike was driven by global supply‑side factors.  There isn’t much monetary policy can do about these shocks and inflation was always going to ease sharply as the supply blockages started to resolve themselves.
• Second, it was a major achievement to drive unemployment down to around 4%, with huge benefits for Australians.  Unemployment in Australia had sat too high for too long, and inflation consistently undershot the target (chart 2).  The Board was right not to throw these labour market gains away too lightly.
• Third, and most importantly, the data supported the strategy.  Until quite recently, inflation was receding, the jobs market was moving steadily back into balance (without crashing) and activity was slowly strengthening and becoming more balanced.

The game’s changed — adapt or fall behind

But the game has changed — and quickly.  The question is not whether the RBA made the right decisions then; it’s whether they can recognise these changes and adapt their strategy to make the right decisions today.

Previously they faced a series of supply‑side shocks.  Public spending and strong population growth kept the economy ticking over, but private sector activity was in recessionary territory.  Against this backdrop, it made sense to adopt a patient approach — keeping modest downward pressure on inflation, while waiting out the effects of these temporary shocks.

Today we face a very different situation.  Pressure has started to come from the demand side of the economy and there still isn’t much, if any, ‘slack’ or room to manoeuvre on the supply side.  In many ways, this is a more dangerous recipe and needs a very different strategy — decisiveness in now in order, not patience.  The balance of risks has also shifted.

As outlined by Belinda Allen and our Australian Economics team, activity has accelerated faster than the RBA expected.  Rapid household income growth has allowed consumers to rebuild savings and still spend more (charts 3 & 4).  Public spending took a small breath but is still supporting growth.  And the combination of AI and the energy transition is finally starting to lift private business investment, despite weak mining investment.

On our estimates, economic growth is already running at around potential (2.1%) and our forecasts have it lifting further to ~2.4% by the end of the year (chart 5).  While this growth rate is still quite modest (and we don’t expect it to ‘take‑off’), there is little economic ‘headroom’ to play with.  Structurally lower productivity is a permanent handbrake on growth and has dragged down potential growth over time (here), and despite easing over the last couple of years, unemployment is still historically low at just 4.1%.

As Deputy Governor Hauser said recently, “inflation above 3 per cent — let’s be clear, it’s too high”.  Since then, we have seen another above target trimmed mean inflation print of 0.9% in Q425 (chart 6).  In our view, some of this price pressure is transitory, but with a strengthening economy and trend unemployment now starting to fall, it is far more likely that price pressures will continue from here, not fall, if left unchecked.

When one mistake matters more

At their February meeting, we expect the RBA Board to respond by hiking rates by 25bp.  However, there is a risk that they continue with their patient approach.  This could see them ‘wait and see’ for a few more months, hoping that ‘transitory’ inflation eases back on its own.

In our view, this would be playing with fire — the RBA now face asymmetric risks.  Let’s look at the two choices and play them out.

• If the RBA holds in February (and then March), and it turns out that growth and inflation are indeed on an upward trajectory, the RBA will quickly find itself a long way behind the curve.  They will then have to hike harder later in the year to be confident of taming inflation, with more severe damage to the jobs market.
• On the other hand, if they hike rates by 25bp in February, and it turns out that growth and inflation pressures are less acute, the cost is likely to be marginal.  Inflation would get back to target a little sooner, growth would be slightly softer and rather than strengthening, the jobs market may track sideways.

In other words, a timely 25 bp hike now won’t crash the economy, but it could prevent a sharp rise in inflation and a steeper rate hiking cycle.

A defining moment

There has been a lot of change at the RBA in recent years — at the Board level and amongst the senior staff.  The outcomes of the RBA Review are also still being bedded down.  We are all still assessing the new Monetary Policy Board’s overall posture and reaction function.  The deliberate lack of forward guidance is making this more challenging.

In our view, the Monetary Policy Board now places slightly more weight on balancing both parts of its dual mandate (full employment and inflation) rather than a ‘fight inflation at all costs’ mindset.  There is also more appetite to challenge the views of the internal staff.

But in our view, that should not be mistaken for hesitancy or a willingness to accept above target inflation.  The bar may be a little higher, but if there is a clear case to act based on the data, we expect the Board will respond.

Today, with trimmed mean inflation sitting well above the target band for two quarters, a strengthening economy and falling trend unemployment, the case for action is compelling and the risk of hesitating is large.

Download this report

• RBA: When the facts change, I change my mind. What do you do? (pdf)