The RBA continues to take few chances when it comes to the problematic domestic inflation trends with another interest rate hike announced today. This is the third consecutive meeting the RBA has tapped on the brakes with the latest 25bp increase moving the cash rate up to 4.35%. Policy settings have been recalibrated quickly. The interest rate ‘relief’ delivered last year has been unwound with the cash rate back at the ‘peak’ reached in the 2023/24 inflation fight.
Today’s decision wasn’t unanimous with the RBA Board voting 8-1 in favour of a hike. It was a matter of when, not if, the RBA acted again with the market assigning a ~75% chance of a move today and another hike fully factored in by the next meeting in June. The focus now is on whether the RBA remains on an inflation war footing and moves interest rates further into ‘restrictive’ territory to definitively win the battle, or if the looming growth slowdown because of the jump in fuel and interest rates causes policymakers to ‘wait and watch’ (chart 1).
According to the RBA “there are materially heightened uncertainties about the outlook”. How/when the conflict in the Middle East plays out is a key part of the puzzle with there being “plausible scenarios where inflation is higher and activity lower than envisaged under the baseline forecast”. Indeed, even the RBA’s baseline forecasts don’t paint a pretty picture and show there are ‘stagflationary risks’ with inflation projected to peak at ~4.8%pa in Q2 and GDP growth slowing to an anemic ~1.3%pa by late-2026 (charts 2 and 3). In time, this more challenging macro environment is expected to negatively impact the labour market with unemployment predicted to edge up to 4.7% by mid-2028 (chart 4).
In the RBA’s opinion, after raising rates three times this year “policy is well placed to respond to developments” and “it will do what it considers necessary” to achieve its objectives. In our judgement, this suggests that while the door to another move is open the data and/or offshore developments will dictate if/when it happens. The reversal in interest rates should help address the demand/supply imbalance and capacity constraints evident across the Australian economy before the conflict in the Middle East kicked off, however the energy price shock stemming from the conflict has created a fresh complication that has left the RBA in a tricky spot. For the Australian economy higher energy prices support the terms of trade and national incomes because of LNG exports, but for Australians already feeling the cost-of-living squeeze it is a negative shock.
In our view, based on the underlying inflation pulse and lingering productivity issues, another interest rate increase by the RBA is more likely than not. However, this is already factored into the interest rate curve with markets pricing in the RBA cash rate reaching ~4.75% by Q1 2027. For the AUD (now ~$0.7137), as mentioned above and previously, we think the pragmatic RBA might struggle to be more ‘hawkish’ than what is baked in. Outcomes compared to expectations matter in markets.
On top of that, we don’t believe the unfolding step down in private sector activity from the double whammy of a surge in fuel costs and higher interest rates have been accounted for. Nor have the global growth headwinds generated by the Middle East conflict and spillover on supply-chains, particularly across Asia. With positioning (as measured by CFTC futures) already quite ‘net long’, and a lot of positives factored in (the AUD is tracking ~2% above our ‘fair value’ estimate), we feel there are more downside than upside risks for the AUD over the period ahead following its strong run (chart 5). As a reminder, we believe the higher level of Australian interest rates and wider yield spreads support a higher average range for the AUD than what we saw the past few years, but not necessarily more AUD appreciation because of what is already discounted and the worsening global/domestic growth trajectory (chart 6).
