RBA Board takes a dovish tilt
The RBA softens rate outlook just when it is increasing its inflation forecast – unusual approach.
The Minutes of the November Monetary Policy Meeting make a clear case for adopting a steady approach to the policy process.
The key section of the Minutes contains a new dimension to the discussion on policy. The advantage of hiking by 25 basis points at the November meeting after having scaled back to 25 basis points in October is “acting consistently would support confidence in the monetary policy framework among financial market participants and the community more broadly.”
That approach would seem to be somewhat inconsistent with the assertion that has appeared in these and previous Minutes, “The size and timing of future interest rate increases will continue to be determined by the incoming data and the Board’s assessment of the outlook for inflation and the labour market.”
When we saw the September quarter Inflation Report, underlying inflation had lifted by 1.8% in the September quarter, significantly higher than the market (and Westpac’s view) of 1.5%, while the broadening of the inflation pressures (nearly 80% of components rising by 3% or more over the year) caused us to lift our forecast for the December and March quarters.
Despite the Minutes noting that the print was “a little above the Bank’s forecast” we note that the Bank raised its forecast for underlying inflation in 2022 from 6% to 6.5% - a significant revision by any standards while surprisingly keeping the 2023 underlying inflation forecast steady at 3.8% and lifting the 2024 forecast for underlying inflation from 3% to 3.2%.
For the record we believe the underlying inflation forecast for the year to June 2023 should be lifted by more than 1% compared to the Board’s adjustment of 0.5%.
This may be partly due to the Bank’s lowering the economic growth forecast (1.8% to 1.4% in 2023) – correctly responding to higher interest rates; lower real wages (higher inflation); and the negative wealth effect.
The Minutes do note that at the November meeting the Board considered both the 25 basis point and 50 basis point options.
Apart from the new “stability” argument the well known points about: full effects of higher rates were yet to be felt in mortgage payments”; “house prices had declined”; wages growth was lagging; and the negative wealth effect had seen a large effect on consumer spending in past cycles were repeated.
But surprisingly, given the uplift in the inflation outlook, there is a hint of a more dovish Board than we have seen recently.
While the Minutes acknowledge, “members did not rule out returning to larger increases” it is highly unlikely that a decision to lift the size of increases would be made by this Board.
Balancing that view is a new insight, “the Board is prepared to keep rates unchanged for a period while it assesses the state of the economy and the inflation outlook.”
The description of the interest rate outlook is also moderated, somewhat.
“The Board … expects to increase interest rates further over the period ahead.” (November Minutes) compared to “likely to require further increases in interest rates over the period ahead.” (October Minutes)
The concept of “drawing out policy adjustments would also help to keep public attention focussed for a longer period on the Board’s resolve to return inflation to target.”, which figured in the October Minutes is not used in these Minutes - trying to lower the expectations for the peak in the terminal rate perhaps.
We do not get a sense as to whether the Board believes that policy is now in the contractionary zone. The Minutes point out that “interest rates were still fairly low in a historical context”. However, the “dovish tilt” in the Minutes implies that the Board assesses that policy is now restrictive – a clear assessment of the current stance of policy would have been welcome.
Review of Forward Guidance
The Board noted that the key complication for forward guidance was to use a time based form of guidance to support the yield target policy. That is an appropriate conclusion and we support the initial decision to use the yield target policy.
In retrospect, the rapid recovery in the economy and associated build up in inflation pressures rendered the policy combination was unworkable. Nevertheless the initial effectiveness of the yield target policy compared to the cumbersome expensive QE policy that was subsequently introduced (and would have been embraced much earlier if not for the Yield Target policy) was., at the time, and given the prevailing forecasts an entirely defensible strategy.
In future the Forward Guidance Policy will be qualitative in nature; flexible and conditional on the policy objectives. Guidance on interest rates will not always be provided.
Forecasts will be published on a regular basis but the Board does not intend to publish its own forecast of the policy path.
That approach is still subject to uncertainty. The practice of using market pricing and market economists’ forecasts for the policy rate effectively means that the forecasts for the policy targets, particularly inflation, may be misleading.
Consider the current situation where the inflation target is not achieved in the forecasting horizon (3.2% by end 2024).
The legitimate question arises as to whether the Board is comfortable to be so far out of line with other central banks or it is just a victim of inappropriate market pricing.
It would be much better to see the Board forecasting its preferred policy outcome with the associated implications for the economy.
If it felt that the impact on the economy of achieving the inflation target too quickly was too severe (note its reference to “ many major central banks …. were more likely to err on the side of doing too much rather than too little”) then it would forecast an extended period outside the target range. That would be a more transparent approach to policy than providing a series of forecasts that are reliant on external parties’ forecasts of the policy rate.
Under that approach it would not be necessary to publish the path of the policy rate.
Conclusion
The Minutes point to a “dovish tilt” to policy where rate hikes in the period ahead are “expected” rather than “likely” and, for the first time, a possible pause has been noted.
That does not put the December move of 25 basis points in any doubt but markets will be encouraged to speculate on further downward pressure on the terminal rate.
However, rising and broadening inflation; likely boosts to wages growth; tight labour markets; and the huge risk that this “flirting” with easy policy can risk boosting inflation psychology still point to the need for the Board to stay the course (in our view, a terminal rate of 3.85% by May) to allow the policy objectives to be achieved.
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