When the Reseve Bank of Australia (RBA) left interest rates on hold in April for the first time in 10 meetings, there was a widespread perception that rate rises were over and a slowing domestic economy would keep the RBA quite cautious.
Considering the premium the RBA has placed on economic growth in the past and its willingness to cut interest rates to support cyclic sectors of the economy over the last decade, this viewpoint was arguably reasonably grounded in a historical precedent.
But in the end, this wasn’t enough to keep rates on hold and on May 2 they went up by 25 basis points. The RBA statement that accompanied the rate rise also signalled that more rate rises may be yet to come, warning: “Some further tightening of monetary policy may be required to ensure that inflation returns to target in a reasonable time frame.”
After the market and most economists got the path of rates so wrong, it’s worth exploring some of the factors behind why the RBA chose to continue to tighten monetary policy and why there may be more rate rises in the months ahead.
Rising global rates and the Australian dollar
Way back at the turn of the 1990s, the RBA cash rate sat a whopping 9.25 per cent higher than the US Federal Funds Rate, the US equivalent. Over the vast majority of the decades that followed, the RBA cash rate remained significantly higher than its US counterpart, providing significant support for the Australian dollar relative to the US dollar.
Fast forward to the present and things have changed dramatically. Despite Australia having higher headline and core inflation (inflation excluding food and energy prices), the US benchmark interest rate sits 1.4 per cent higher than the RBA cash rate, with the interest rate differential now acting as a headwind for the Australian dollar rather than a boost.
With the overwhelming majority of Australian consumer good imports paid for in US dollars, the relative strength of the Australian dollar can be of particular concern for the decision makers at the Reserve Bank.
RBA’s preferred inflation metric
Despite the large improvement seen in the headline rate of inflation in the first quarter of this year, which saw a significant fall from 7.8 per cent to 7.0 per cent, the RBA’s preferred inflation metric, the ‘trimmed mean’, saw a much smaller fall.
The trimmed mean is calculated using the weighted average of the inflation experienced by the middle 70 per cent of the CPI basket, with the 15 per cent experiencing the largest rises and the largest falls excluded from the calculation.
In Q1 the trimmed mean fell from 6.9 per cent to 6.6 per cent. The decrease was a highly welcome move and a hopeful sign that inflation had peaked, but the pace leaves something to be desired.
Services inflation is still rising
Around the globe, inflationary pressures were led out of the gate by goods inflation, as supply chain issues and the rising cost of raw materials saw the price of goods take off. In time, goods inflation faded in much of the world and in this Australia has been no different. Goods inflation peaked at 9.6 per cent in the September quarter and has since fallen to 7.6 per cent in the first quarter of 2023.
Unfortunately, like the rest of the world, services inflation is now taking hold in the economy, and on this metric, inflation is yet to peak, with services rising by 6.1 per cent over the past year and potentially still accelerating.
This particular form of inflation is of great concern for the RBA due to it historically taking significantly longer to bring under control than goods inflation.
Baked in inflation
For most of the last decade, capital city rents have lagged behind the headline rate of inflation, with rents nationally rising by just 0.2 per cent in the last year, unimpacted by the pandemic. But after a decade of playing a major role in reducing the rate of headline inflation, that is set to change in a big way.
According to data from private providers such as PropTrack, Domain and SQM, capital city asking rents are rising significantly faster than the rental component of the Consumer Price Index. According to the Australian Bureau of Statistics (ABS), capital city rents overall are up 4.9 per cent in the past 12 months.
Meanwhile PropTrack sees asking rents up by 13 per cent, CoreLogic by 11.5 per cent and SQM by 21.1 per cent. It’s worth noting that the ABS measures all rents in aggregate, while the data of private providers measures asking rents for new leases.
However, historic data shows that the ABS figure tends to lag behind those of private providers and eventually catches up in time.
If the ABS metric was to record the same rental price growth as private providers as it catches up – as it has historically – it would increase the contribution of the rental CPI component from 0.66 per cent to 1.21 per cent annually. Considering the RBA’s inflation target is 2-3 per cent, that is an extremely large amount of inflation to be coming from a CPI component that makes up just 5.75 per cent of the overall index.
The outlook
In the statement that accompanied the recent rise in interest rates, the RBA made it clear that further rate rises were well and truly on the table. While the current high levels of uncertainty in the global economy and the financial system complicate matters significantly, they may not be enough to give the RBA a more permanent pause.
Considering the aforementioned issues with high domestic inflation and potential exposure to currency weakness, the RBA may not be finished with raising rates and if the global economy continues to hold up OK, it’s possible there may be more rate rises to come.
Tarric Brooker is a freelance journalist and social commentator | @AvidCommentator