Is this the end of interest rate hikes?

Background – Inflation target and monetary policy 

Since the early 1990s, the RBA has used an inflation target to achieve its monetary policy objectives, stating that maintaining low and stable inflation is important for achieving sustainable growth in economic activity and employment. 

Monetary policy involves setting the interest rate or ‘cash rate’, which influences economic activity, employment and inflation. The RBA is responsible for monetary policy in Australia. 

Monetary policy aims to keep consumer price inflation (CPI) between 2 and 3 percent, on average, over time.

The Reserve Bank Board has three objectives when setting monetary policy: 

• The stability of the currency of Australia
• The maintenance of full employment in Australia
• The economic prosperity and welfare of the people of Australia 

The Board takes into consideration a wide range of factors, including domestic and international economic and financial conditions, along with the outlook for economic growth and inflation in Australia. These considerations are used to implement a ‘target cash rate’, essentially used as a lever to speed up or slow down economic activity in Australia. 

An unprecedented rate hiking cycle 

Throughout 2022 and 2023, the RBA has embarked on the largest historic cycle of interest rate increases since the inflation targeting mechanism began in the early 1990s. The RBA has increased the cash rate by a total of +3.50% over 10 consecutive meetings from May 2022 to March 2023. Starting from the all-time historically low level of 0.10% to 3.60% on 8 March 2023. The current cash rate is the highest since 2012. 

The largest previous rate rise cycle was +2.75% in late 1994 over three non-consecutive meetings – although interest rates were significantly higher than current levels in the early 1990s. Of course, there have also been some large decreases during periods of financial turmoil such as the Global Financial Crisis and Covid pandemic. 

A fight between inflation and economic stability 

Over the last few weeks, debate has increasingly focused on whether the RBA would pause its current rate tightening cycle, as it attempts to return inflation back to the 2 to 3 percent target level without causing severe damage to the economy and resulting unemployment. 

The reality is, during March the US Federal Reserve illustrated its resolve to fight inflation by increasing rates another 0.25%. If nothing else, this sends a signal to the markets on their determination and the likely path forward. It also appears that some other central banks are also wary about giving up the inflation fight too early. 

While overseas activity is some guide, the RBA has stated in recent months that a number of data points would determine whether a rate pause would occur – the unemployment rate, monthly inflation, retail spending, and business conditions.

The unemployment rate in Australia fell further to 3.50% in February and surveyed business conditions have remained reasonably strong – strengthening the case for another rate rise. 

However, the new Australian Bureau of Statistics monthly inflation (CPI) indicator fell to 6.80% year-on-year to February from 7.40% the prior month. Retail spending, while remaining level, is losing momentum. These two data points supported the case for a pause in interest rate increases. 

Why Australia differs from other countries

The Australian economy differs to other countries, which is why the RBA won’t always follow the actions of other central banks.

Perhaps the largest difference in Australia to the US and many other developed economies is the level of household property debt via mortgages, mostly with variable rates. In the US a typical mortgage is up to 30 years in length and is fixed rate. As such, rate rises in the US have less impact on households and consumption.

The RBA has a difficult balancing act between inflation targeting and its other objectives including the maintenance of full employment and economic prosperity. 

This balance is made harder by the fact that the population is not homogenous and the impact from higher mortgage rates is not evenly spread, meaning there is a risk that those with less equity in their homes or with less disposable income will ultimately feel a much larger impact. 

Given the sensitivity of the Australian economy to higher interest rates, there is a risk that the current rate rising cycle results in severe damage to the economy or the welfare of Australians. 

For that reason, and the delayed impact of interest rate rises, the RBA is being cautious leading to its decision to pause the interest rate hiking cycle and leave the cash rate unchanged at its April board meeting. 

What does this mean, and what do we expect next?

The RBA’s decision to pause is fundamentally driven by signs of peaking inflation, slowing economic growth, and recent global market events which have driven greater economic uncertainty – making it prudent for the RBA to pause and assess the implications of the interest rate hikes to date. 

This does not mean that the current rate cycle is over. If inflation remains high relative to targeted levels and the economy remains strong, the RBA will likely continue to raise rates, although more slowly.

If economic data weakens, the RBA will likely remain on hold for longer as they assess the impact and ensure the risk of slowing the economy too much is mitigated. 

However, one benefit of interest rates being significantly higher now than they were in early 2022, is that the RBA now has the ability to reduce rates if weakness emerges in the economy. And, let’s not forget fixed income and cash investors. Ultimately, higher interest rates, yields and levels of return are beneficial for these investors.