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Interest Rate Update: How high, how fast

07 June 2022

RBA announcement:

The RBA increased the cash rate by 0.5 percentage points at its June meeting;
The RBA indicated that inflation in coming months could be higher than they anticipated as recently as last month;
Economists widely agree that the current level of inflation and the unemployment rate will require further rate rises;
But how high the cash rate needs to get in this cycle, and how long it takes to get there, is the key point of debate.

For the second meeting in a row the RBA surprised financial markets and increased interest rates by a larger than expected amount (0.5 percentage points). The size of such a move is the same as what other central banks (US, Canada, New Zealand) have recently delivered. I had thought they would raise rates by 0.4 percentage points, in part to take the cash rate back to an even quarter amount (following the June move the cash rate is 0.85%). Clearly that argument did not rate with the RBA.

The analysis contained in the monetary policy statement did not surprise. The RBA thinks economic growth is strong, with further declines in the unemployment rate likely. Inflation could head even higher than was envisaged even one month ago, reflecting movements in electricity and gas prices.

They noted the significant uncertainty about the outlook, notably about household spending (and how it is influenced by higher inflation and falling house prices). Other concerns included high commodity prices and how that would impact global economies as well the uncertainties associated with COVID (notably in China).

Barring some unforeseen development, the statement following the meeting made it clear that the move in June will not be the last. An economy with an unemployment rate in the 3’s and an inflation rate in the 5’s does not need a cash rate of under 1%. In March, the cash rate after allowing for inflation (‘real cash rate’) was at its lowest level in at least forty years. Using RBA inflation forecasts and financial market pricing of future cash rate movements, the real cash rate would still be at historically low levels by the end of next year.

That the cash rate will be heading higher is widely agreed amongst economists and financial markets. The big disagreement is how high the cash rate will need to go and how long it will take to get there. Before the June meeting the expectations for the cash rate by the end of this year ranged between 1 - 2.6%, with 1.75% the most popular projection.

If the RBA does take the opportunity to raise the cash rate by 0.4 percentage points (to get the cash rate level at a quarter percentage point) at its July meeting, then they might take a meeting off to see how higher interest rates are impacting the economy. Otherwise, another 25bp at the July meeting, followed by a further 25bp at its August meeting, is a real possibility.

Where does the cash rate get to by the end of this year? I had been thinking 1.5%, as this was the level that might start to impact household spending. They would then give themselves the summer to see how higher interest rates were impacting the economy before moving again. But the RBA has mentioned that a more neutral (or typical) cash rate is somewhere around 2-3%. And other central banks (such as the Federal Reserve, Bank of Canada and Reserve Bank of New Zealand) are either at 2%, or will shortly be there.