Market Musing: RBA: Back in the inflation fight
The RBA has returned from its summer break and raised interest rates by 25bps, lifting the cash rate back up to 3.85%. Today’s unanimous board decision was expected by most surveyed economists and ~70% priced in by markets (though this was a timing not direction difference with markets fully discounting a rate rise by May ahead of today’s meeting).
We had been flagging that an RBA policy U-turn was on the cards given the Australian economy is operating at a high level (as shown by above average capacity utilization and low unemployment), private sector activity is picking up, and inflation is too high. The RBA agrees noting “labour market conditions remain a little tight”, “private demand is growing more quickly” and “inflation is likely to remain above target for some time”. Because of the “greater capacity pressures” the inflation outlook and risks have changed, which in turn means policy settings need to be ‘recalibrated’ to more ‘restrictive’ levels. Indeed, as our chart shows, periods of above-average capacity utilisation in Australia have typically been associated with rate increases rather than rate cuts as they were last year. In hindsight, along with not lifting rates far enough during the tightening phase (recall the RBA elected not to raise rates as much as its peers to preserve COVID era jobs growth), the RBA’s modest 2025 easing cycle looks like it was an error (chart 2).
Where to from here? According to the RBA it “will do what it considers necessary” to achieve its price stability and full employment mandate. Governor Bullock proclaimed she won’t be “making predictions” about the interest rate outlook, and stated that while it “cannot allow inflation to get away from us again” the Board is “going to be cautious”. That said, in our mind, underlying trends across the domestic economy and the RBA’s refreshed forecasts suggest the interest rate reversal has further to run. Another rate rise over the next few months, probably after the next quarterly CPI inflation report (i.e. the 5 May meeting) looks more likely than not, in our view. Put simply, we doubt a single 25bp interest rate tweak will be enough for the RBA to break the back of inflation, and it is debatable whether one more hike from here will get the job done.
According to the RBA’s updated projections core inflation is set to accelerate further near-term, hold above target over 2026, and then gently ease to ~2.6% by mid-2028 (chart 3). This reflects a slower growth trajectory (Australian GDP growth is predicted to decelerate to a below trend ~1.6%pa pace) and higher unemployment (now seen peaking at ~4.6% late in the forecast horizon) (charts 4 and 5). Notably, this more challenging economic backdrop assumes interest rates rise to ~4.3%, ~100bps higher than the last set of RBA projections put together late last year. Hence, the RBA might need to crystalize these aggressive interest rate assumptions otherwise inflation may be even higher or outside of the target range longer than anticipated.
In terms of FX, the AUD has jumped up a long way already this year (now ~$0.7010, +5% year-to-date) and is up in a region it last traded in February 2023. The AUD has moved in the direction we have long been forecasting, though admittedly the appreciation over the past few weeks has been faster than envisaged (we have been projecting the AUD to rise to ~$0.70-0.71 by late-2026). In our view, the RBA’s ‘hawkish’ vibes, and the shift in relative interest rates in Australia’s favour should be AUD supportive over the medium-term (chart 6), however a lot of positivity already looks to be in the price, in our view, with the AUD tracking a little above our yield spread centric and broader ‘fair value’ models (charts 7 & 8). With this in mind, and with the negative economic impacts of higher interest rates set to materialise over the months ahead, we continue to think ~$0.71-0.72 may prove to be a ceiling for the AUD without another stepdown in the USD.
Peter Dragicevich
Currency Strategist - APAC
About the author
