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As the Fed continues to tighten, can the RBA afford a dovish pivot in October?
The long-held dovishness of the Reserve Bank of Australia (RBA) has certainly been no tight-lipped secret.
After it never should have done so in the first place, the RBA continued to repeat its now infamous expectation that interest rates will not be raised until 2024 for far too long. The RBA then lagged international counterparts such as the Federal Reserve (Fed) in finally raising rates (the Fed first raised rates in March 2022 versus the RBA in May 2022)—which is significant given that the Fed also got its policy settings, and their inflation consequences, very wrong.
While the RBA has increased interest rates by 50bps in each of the last four months, taking the cash rate to 2.35 per cent, the minutes of its September monetary policy board meeting yet again reveal a dovish tilt. Namely the RBA noted: that members “discussed the argument around raising interest rates by either 25bps or 50 bps”; that monetary policy operates with a lag and is getting closer to normal settings; that the full effects of higher interest rates were yet to be felt in mortgage payments; that whilst the Board was “resolute” in the need to return inflation to target, the path “needed to account for risks to growth and employment”; and that “the case for a slower pace of increase in interest rates [is] becoming stronger as the level of the cash rate rises.” While stating that interest rates were still expected to increase in the months ahead, the RBA nevertheless sent relatively clear signals that interest rate hikes may soon begin to slow.
Compare this to the Fed, who just raised interest rates by 75bps for the third consecutive month, to 3-3.25 per cent and signalled a median year end federal funds rate projection of 4.4 per cent (a level which the RBA would remain well below, even if it delivered three further consecutive 50bp rises to end 2022). In his September FOMC press conference, Fed Chair Powell noted that the Fed is taking “forceful and rapid steps to moderate demand”. Clearly, there is a divergence between the current rhetoric and policy signalling coming out of the RBA and the Fed.
In light of the recent sharp devaluation of the British pound, and as the AUD/USD has recently fallen below 65c, can the RBA afford to not only continue with its relatively more dovish rhetoric, but pivot to a slower pace of interest rate increases at its October meeting, as some expect it to do? Let’s now explore some reasons for and against doing just that.
Tradables lead Australia’s inflation, making further weakness in the AUD/USD unhelpful
Whilst the benefits of globalisation have meant that tradables prices generally grow at a significantly lower rate than non-tradables prices (Figure 1), over the past year this relationship has reversed significantly, with year-on-year (YoY) tradables price growth of 8.0 per cent in the June quarter, versus 5.3 per cent for non-tradables prices (Figure 2).
The significant increase in tradables prices stems in part from the significant global stimulus measures that were deployed by policymakers around the world, and which caused a surge in global demand. While Australia’s domestic policies contributed somewhat to this global demand surge, with Australia being a relatively small nation, the prices it pays for imported goods are more heavily influenced by larger nations such as the US, who have a disproportionate impact on global demand.
Given that larger nations such as the US saw more extreme increases in their broad money supply than in Australia (Figure 3) (the US’ measure of the broad money supply is M2. Australia does not have an M2 designation, with M3 representing a broad measure of its money supply), the surge in global demand for goods that this caused, likely acted to create additional inflationary pressure over and above that which was created domestically by Australian policies. This phenomenon is evidenced by the difference in Australian and US CPI growth, where whilst following the same trend, post-COVID inflation in Australia has remained below that of the US (Figure 4).
Further still, and despite a record terms of trade (Figure 5) and trade balance (Figure 6), the seemingly continuous surge in the USD has not spared the AUD, which has not only fallen below 65c, but is now trading at around the 64c level. With Australia importing critical items like oil/fuel, as well as most of its durable goods, the weakening AUD/USD has further impacted tradables price growth. By reducing the pace of interest rate rises whilst central banks worldwide are by and large becoming more aggressive with their monetary tightening, the RBA risks a further significant decline in the AUD/USD, exacerbating tradables price pressures.
Australia continues to see robust growth in credit and the money supply—meaning more tightening may be needed
Despite Australia’s recent interest rate rises, its credit and money supply continues to grow at a robust pace.
Total credit growth increased at a YoY rate of 9.2 per cent in July, with total business credit growing by 13.4 per cent over the year to July (Figure 7). Strong business credit growth is aligned with continued robust growth in GDP, which grew by 0.9 per cent over the June quarter, further suggesting that the Australian economy is in a much stronger position to tolerate further interest rate hikes versus the US (which has recorded two consecutive quarters of negative GDP growth), and European nations, which are plagued by extreme energy prices.
In terms of housing credit, while new home loans have slowed notably in recent months (Figure 8), they continue to be well above historical levels, resulting in total housing credit growing by 7.7 per cent in the year to July (Figure 7).
Continued robust growth in credit has resulted in ongoing strong growth in Australia’s M3 money supply, which has increased by 9.1 per cent over the 12 months to July (Figure 9), and in which the average MoM growth rate over the past 3 months has been 1.1 per cent. There would thus appear to be a solid argument that further significant rate rises are necessary to reduce Australia’s credit and money supply growth, and in-turn, reduce the pace of demand growth.
Contrast Australia’s continued strong growth in its money supply to that of the US, which despite growing at a much faster rate than Australia’s following the onset of COVID, has seen a flatlining in its M2 money supply in 2022 as a result of its recent fiscal and monetary tightening. This flatlining of M2 during 2022 has resulted in an ongoing dramatic deceleration in the US’ YoY money supply growth rate, and which is likely to show practically no YoY growth by the end of year—indicating that tightening in the US has had a much more significant impact than in Australia.
But Australia’s inflation rate may fall on account of others doing more
While the impact of a lower AUD/USD on tradables prices, and the ongoing robust growth in the money supply both suggest a need for significant further tightening by the RBA in order to rein in inflation, one must also remember that Australia’s import prices, and its export orientated economy, are both significantly impacted by larger nations like the US and China. So whilst Australia’s tightening has not had a significant impact on reducing its money supply growth, significant tightening in the US has achieved just that.
This is likely to result in a significant reduction in the pace of global demand growth for durable goods, and which has already contributed to a deceleration of YoY durables price growth in the US (Figure 10) - and which is likely to decline much further as higher YoY comparables are cycled from October to January (Figure 11). The lessening of global demand and associated supply-chain pressures can also be seen in the decline in global shipping prices (Figure 12). This is likely to flow through to reduce Australia’s tradables inflation price pressures over time.
As the US and Europe teeter along the edge of a recession, and as China’s economy remains sluggish amidst continued COVID lockdowns and a property slowdown, the outlook for commodity prices also remains fraught. The potential for significant declines in commodity prices from current levels would have a significant impact on Australia’s economic growth, and in-turn its business credit growth, likely helping to reduce growth in its money supply.
While this suggests that the RBA may be somewhat wise in adopting a more dovish approach versus most other central banks, the key caveat is that the RBA walks a fine line between getting too dovish versus the Fed, and risking a significant further decline in the AUD/USD.
Current credit data is lagging: credit growth may have potentially slowed in the past two months
As the RBA noted in its most recent board minutes, the full effect of interest rate rises have not yet been felt. So whilst the most recent credit data suggests that rate rises have not yet had a significant impact on lending, the latest data is from July. Since then, the RBA has delivered a further 100bps of additional interest rate hikes. It may become apparent as credit lending data is updated in the weeks and months ahead, that this additional tightening versus July levels has had a sufficient enough impact in constraining credit growth.
The best pathway is all but clear, but another 50bp increase would appear to be the more straightforward option
Taken in totality, one can see that the correct pathway ahead for the RBA is all but clear. On the one hand, a continuing decline in the AUD/USD, and continued robust credit and money supply growth suggest that the RBA needs to do significantly more to lower inflation. On the other hand, the global demand outlook would appear to be lackluster at best, with the US, Europe, and China all likely to either see negative or slow growth over coming quarters. This would suggest that Australia’s tradables prices should decelerate over time. Such lacklustre demand is also likely to have flow-on impacts to commodity prices and Australia’s economic growth. Additionally, Australia’s credit growth may have slowed in the latest two months, for which data is not yet currently available, but in which time the RBA delivered 100bps of additional interest rate hikes.
Since COVID, the RBA has maintained a relatively dovish position, and its most recent minutes suggest it has/is significantly contemplating slowing the rate of interest rate hikes from their recent 50bp rises. Though with the Fed continuing to forcefully and rapidly apply monetary tightening; the RBA no doubt taking note of the recent major slump in the British pound; and financial markets pricing in a 76 per cent chance of another 50bp increase in rates to 2.85 per cent at the RBA’s October meeting (as of 27 September 2022), the more straightforward choice would appear to be another 50bp hike in October. A pivot to a lesser 25bp hike in October may instead be viewed by financial markets as premature, and as being significantly out-of-step with the Fed and other central banks, and which would place significant additional downward pressure on the AUD/USD.
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