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The RBA Pauses Early – what are the risks?

• The RBA opted to pause rate increases last week. That is despite inflation that is well above target and forecast to stay that way for a couple of years, labour markets that remain tight, and other central banks pushing rates faster and further into restrictive territory.  Governor Lowe in his speech last week made explicit what had been evident in the RBA’s actions: the Bank is leaning fully on flexibility in the vaguely defined inflation target (“between 2 and 3 per cent, on average, over time ”) in the hope of preserving gains in the labour market. In doing so they are preferring to err on the side of doing too little rather than too much. Will they pull it off? Or will the risks of more persistent inflation be realised?
• NAB’s central case is that the peak in the cash rate is, though the risk is to the upside in the near term with the RBA to remain reactive to the data flow, especially around inflation and wages. The decision by the RBA to pause came slightly sooner and slightly lower than we had earlier expected based on our assessment that the risks were not yet sufficiently balanced.
• In this note, we paint the optimist’s view that the RBA can be done at 3.60%, and also detail what would cause the RBA to continue their hiking cycle. The RBA has been highly reactive to the dataflow, and we expect that will remain the case:
  • In the optimist’s view are well told stories of the outlook for goods and construction disinflation which will certainly help. To complete the job though services inflation will need to moderate. Services capacity is now largely rebuilt and pent-up services demand is fading. Key to the RBA’s forecast is that wages growth remains consistent with inflation if productivity growth lifts. Over 2022, unit labour costs rose well in excess of base wages, meaning it is plausible that labour cost pressures ease even while base wages growth picks up a little further.
  • The pessimist’s view is the above is not enough. Rates may not be sufficiently restrictive, leading to a more protracted and painful adjustment to break the back of persistent inflation. The tentative signs of moderation the RBA have noted could turn out to be insufficient to get demand better aligned with supply after the strength of spending out of the pandemic. Higher-for-longer inflation and still tight labour market also risks an ongoing wages response and a shift in expectations that see high inflation persist.

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