Interest Rates – What The RBA Said Today

No surprise at today’s announcement by the Reserve Bank of Australia (RBA) that interest rates remain on hold, for now.

The Bank noted that while the global economy is recovering from the pandemic, the Ukraine crisis has added a degree of uncertainty to world economic growth, especially given the rising cost of energy. Energy prices are a component of the CPI, which is now forecasted by the RBA to increase to around 3.25 percent in 2022. The RBA expects inflation to then settle at around 2.75 percent throughout 2023. The Bank has pointed to the potential for higher petrol prices to continue and for supply-chain disruptions to take longer than expected to resolve. These factors are feeding the uncertain outlook for inflation, which in turn creates a heightened level of uncertainty around the interest rate outlook generally.

Inflation, wages and employment are the numbers to watch

Inflation is the key driver of long-term interest rates. The RBA sets interest rates at a level that keeps inflation within the range band of 2-3 percent, on average, over time. It does this by moving the cash rate, which is in effect, the barometer that sets the rate (‘temperature’) on which lenders’ rates within the broader economy are based. This includes residential mortgage rates charged by banks and the burgeoning non-bank lending market funded by mortgage-backed securities. The cash rate is currently set at an all-time low of 0.1 percent, or one tenth of 1 percent.

Inflation, as measured by the Consumer Price Index (CPI) is impacted by many variables, because it is a measure of the average prices paid by Australian householders for everyday consumer goods and services. It is a composite number that measures average living costs for everyday Australians. This is why the RBA pays close attention to the CPI number each quarter.

Inflation is currently running at 1.3 percent for the December quarter, taking the annual headline 2021 inflation rate to 3.5 percent.  The RBA notes that inflation is being driven by rising petrol prices, higher new home prices and higher costs for some goods affected by supply chain disruption. This implies an underlying inflation rate of 2.6 percent. The current RBA interest rate policy includes a target inflation range of 2 to 3 percent.

As well as managing inflation, the RBA also looks to manage the employment level in the Australian economy. Unemployment is presently sitting at 4.2 percent, being a 14-year low. Economists consider that the ‘natural‘ rate of unemployment is 4 percent, implying this is a state of ‘full employment‘. The significance of this number is that unemployment below 4 precent is considered to be conducive to wages growth above an acceptable level, beyond which inflation in the form of higher consumer prices is likely to emerge. This is when the RBA is compelled to act by increasing interest rates to ‘slow‘ the rate of economic growth back to a level that is not inflationary.

The Australian economy is now heading toward this tipping point, where accelerating wages growth from a tightening labour market is likely to feed into higher consumer prices. Wages growth, based on the most recent data release is comfortably below 3 percent, however, most economists expect that by September this year, annual wages growth will be above the 3 percent tolerance level, and unemployment less than the 4 percent benchmark, at which point wage growth rates begin to accelerate. The RBA consider that wages growth will be gradual, however acknowledge that wages growth can accelerate during times of historically low levels of unemployment.

This blend of accelerating wages growth and falling unemployment at a time of record low interest rates, is a cocktail for a rate rise………….or two………..or three.

Come the September RBA meeting, there should be sufficient wage data to form a considered view on wages growth, which will be a key determinant of interest rates.

On present indications, there is sufficient momentum building on the wages and employment growth fronts to suggest that Australians should brace for an interest rate rise from late calendar year 2022.

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