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Economic and Financial Market Update: Interest rates - what can history tell us

06 May 2022

Summary:

The RBA hiked rates by 0.25 percentage points at its May meeting;
The move was higher than what financial markets had anticipated;
This move will almost certainly not be an orphan with another rate increase likely next month;
Financial market pricing of the amount of rate hikes is aggressive compared with economist forecasts and the history of moves in the low inflation era.

Going into the May RBA Board meeting economists thought the three possible scenarios were possible: no move, a 0.15 rise or a 0.4 percentage point hike. Financial Markets were fully priced for a 0.15 percentage point move. By moving by 0.25 percentage points (to 0.35%) the RBA obviously wanted to do something different for its first move in over one year.

The reason given about why interest rates have gone up is what you would expect: the economy is doing so well it doesn’t need more help and inflation is rising strongly. The RBA appears comfortable about the economic growth outlook although they acknowledge the various risks (China and COVID, Russia-Ukraine the impact of higher inflation). The RBA are forecasting that the unemployment rate will decline to 3.5% by early next year and remain there. The RBA suggested that much of the recent rise of inflation has been down to global factors although they noted that domestic factors are playing an increasing role. A further rise in the annual inflation rate is expected over the next 3-6 months (although I think the largest quarterly rise may have already happened). Inflation is then expected to moderate, with 3% the forecast by mid-2024. Using as evidence their liaison program and business surveys the RBA feels confident that wages growth is rising despite it not yet been evidence in the economy-wide data.

The statement released post the Board meeting made it evident that there are more rate hikes to come. I would expect the next move to be at the June meeting. In both the past two tightening cycles the RBA moved at back-to-back meetings at the beginning of its tightening cycle. In a subsequent press conference the RBA Governor indicated that 0.25 percentage point was chosen as the RBA wanted to give the impression that ‘things were returning to normal’. This suggests that future rises of 0.25 percentage points is the most likely outcome. The RBA has also historically focussed upon moving the cash rate quickly back to a particular level at the beginning of a rate hike cycle.

In his press conference the RBA Governor nominated 2.50% as the sort of level that the cash rate might be heading towards without any promises that level will actually be achieved. At the time of writing, financial market pricing was substantially more aggressive.

As expected the RBA also decide to reduce the size of its balance sheet. It will do this by not re-investing the bonds as they mature and allowing the term funding facility (cheap funding to banks) to come to an end.