The August Statement on Monetary Policy sees inflation success without further rate hikes
The RBA’s forecasts still do not see inflation reaching the mid-point of the target band by end 2025. The Board seems relaxed about this although such an approach has many critics. While it considers “insurance” hikes, the forecasts do not support that need. With the Board now seeing inflation risks as evenly balanced, the case for stable rates has been boosted by this SOMP.
The August Statement on Monetary Policy (SOMP) provides an update to the Bank’s forecasts from the May Statement.
The forecast horizon has been extended from June 2025 to December 2025.
As we expected, following the Governor’s Statement after the Board meeting on August 1, the inflation forecasts still do not envisage either core or headline inflation reaching the middle of the target band (2.5%) by December 2025. Both headline inflation and trimmed mean inflation are forecast to reach 2.8% by end 2025.
This “patience” risks undermining the message that the Board is committed to returning inflation to the target in a reasonable time.
The forecast for headline inflation in 2023 was lowered to reflect the better than forecast outcome to June (6.0% down from 6.3%) but no meaningful improvement is assumed for the second half of 2023, with the forecast fall of 1.9ppts in August compared to 1.8ppts in May.
The forecast fall in headline inflation in 2024 was 1.3ppts in the May SOMP compared with 0.8ppts in the August SOMP. That seems a little strange although it may be driven by the desire for inflation to reach an unchanged end 2024 level despite the lower starting point in August.
A much closer assumption is made for the core measure, with inflation falling by 0.9ppts in the May SOMP compared to 0.8ppts in the August SOMP through 2024.
For August, the forecast slowdown in inflation in 2025 is much more sedate than 2024, falling by 0.5ppts for the headline measure and 0.3ppts for the core measure.
The growth forecast for 2023 has been lowered from 1.2% to 0.9%; and from 1.7% to 1.6% for 2024. These numbers emphasise the likely downdraft that weak growth in demand can be expected to exert on inflation.
These forecasts are in line with Westpac’s forecasts of 1.0% and 1.4% respectively.
The forecast for the unemployment rate was lowered marginally for 2023 (4.0% to 3.9%) but remain the same for 2024, at 4.4%.
These forecasts compare with Westpac’s forecasts of 3.8% and 4.7% respectively.
The forecasts for August are based on a peak cash rate of 4.25% compared with 3.75% in the May SOMP – that largely reflects the May and June rate increases which were not anticipated generally by the market or the professional forecasters (forecasts are based on the average of market pricing and forecasts of the professionals).
With the cash rate now at 4.1% the forecasts are effectively based on a flat profile for the cash rate.
Therefore, the forecasts are telling us that the Bank believes it can achieve its target without any further interest rate increases.
My experience with international observers of the RBA’s policy approach indicates a degree of dissatisfaction that the Board is not targeting the middle (2.5%) of the policy target band. That issue was also raised in the recent RBA Review, where an approach to target the mid-point of the band was favoured.
The commentary in the SOMP seems to be marginally more dovish than other recent communications from the Bank.
SOMP’s always give considerable attention to the risks around the inflation outlook.
In particular, the Overview in the SOMP noted that “the risks around the inflation outlook are broadly balanced”.
This contrasts with the recent theme that the Board was concerned about inflation overshooting the target (see commentary in both May and June).
While the Board did consider a rate hike at the August meeting, as has been the case for every meeting since May last year, the attraction of taking more time to assess the cumulative impact of the tightening cycle was clearly the preferred option.
Although this approach is not apparent in the revised forecasts (no lowering of the inflation forecasts by end 2024 or mid 2025), the Board does conclude that “the data in recent months have confirmed that inflation is moving in the right direction and are consistent with inflation returning to the 2-3% target range over the forecast period.”
The ongoing concern with weak productivity and rising unit labour costs is also prominent, while the forecasts continue to be based on a return to the modest productivity growth we saw before the pandemic. Real concern around this issue should be apparent in the inflation forecasts for 2024. Although we did see a more modest fall in forecast headline inflation in August than we saw in May, that was not replicated in the core inflation forecasts, implying that the productivity “concern” does not figure in the central forecasts.
The mandatory risk issues are still considered, including the upside risks to wages growth over the second half of 2023 (tight labour market; impact of minimum wage decisions; unresolved increases for the public sector). The SOMP also noted that tightening policy could provide further insurance against the upside risks to inflation.
That insurance opportunity was clearly available from the August Board meeting and was the basis of Westpac’s incorrect forecast, but it was not taken up.
As the economy and inflation slow (note RBA’s 1% growth forecast for 2023), the case for “taking insurance” will surely dissipate as we move forward.
Indeed, the time should be at hand when the Board will feel comfortable to drop the soft tightening bias “some tightening of monetary policy may be required”.
The forecasts, which only include around 12 basis points of tightening over six months, are consistent with achieving the RBA’s target without further rate increases. So while the “soft bias” can be used, it is not consistent with the forecasts.
Other encouraging observations in the SOMP are: “the monthly CPI indicator points to easing inflationary pressures”; “short-term inflation expectations have declined”; and “most medium and long-term inflation expectation measures remain consistent with the Bank’s inflation target”.
Conclusion
The forecasts and commentary in the SOMP, while pointing out the risks, support the case for the RBA to remain on hold.
Inflation risks are perceived to be evenly balanced and growth is forecast to slow to a limp 1% in 2023 despite strong population growth, before recovering to only 1.6% in 2024.
Waiting to assess the cumulative impact of the rapid tightening cycle appears to be the dominant policy motive of late; and the August SOMP’s forecasts are based on a flat trajectory for the cash rate to achieve the target.
The most respectable argument for higher rates is that the forecast – which are based on flat rates – does not see the inflation rate returning to the middle of the target band.
It appears for this Board that bringing inflation back to just “within” the band is sufficient.
Westpac is broadly comfortable with the RBA’s forecasts and the conclusion that rates have peaked prior to the first rate cut, which is likely for the September quarter next year.
The issue of not returning to the middle of the band may well have to be considered at a later date, but by then I think it is likely that it will be possible to credibly forecast that return without resorting to higher rates.
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