Turning the Ship

Should the RBA break with it's previous guidance?

All eyes this week turn to the RBA to see if they will make their second ever election campaign hike at their meeting on Tuesday.

Will they take the plunge? 

From an economist's point of view the precise timing of these cuts doesn’t really matter. In fact the RBA’s quarterly models of the economy cannot even distinguish between cutting in May vs June as they both occur in the second quarter of the year!

The question of whether to hike is less one of formal economic models, but a question of guidance and signalling. The RBA faces a trade off between following the data and keeping to their previous guidance.

There is no doubt that last week's CPI release was a bomb-shell coming in significantly higher than expected. It surely meets the RBA’s test of having inflation back within the target band (indeed it is now above the target band!).  The only question is whether it satisfies the RBA that inflation is sustainably back in the target band.

The need to see a sustainable increase in inflation is why the RBA previously signalled that they would wait until June when they would have the first ABS data on wage growth in 2022.  A sustainable ongoing rise in prices will only happen when wage have also started growing too, which is why the RBA was going to wait until the WPI was released until it made a final decision about when to lift interest rates.

However this logic was overturned by the strong CPI print. In particular the RBA will be paying careful attention to the very high rate of inflation in non-tradable goods up 1.8% in the quarter and 4.2% over the year.

There are lots of ways to break down a CPI report.  You can look at the individual categories of goods and services such as food or education services, you can break it down geographically across the different states. But most analysts today will be looking at the split between tradable goods (think oil, wheat and flat screen TVs) and non-tradable goods (such as haircuts, plumbers and utilities).

This distinction is particularly important today because there is currently a series of large shocks affecting the supply of tradable goods, notably the war in the Ukraine and the lockdowns in China. Even an extremely high CPI print could be written off if it was largely confined to tradable goods inflation only. We don't know how long these international shocks will occur, but if they quickly subside then so will the inflationary pressure. For inflation to be higher on a sustainable basis we will need to generate those price increases in the domestic economy.

That's why the high rate of non-tradable inflation will be of such concern to the boffins of Martin Place. It is a sign that the domestic economy is heating up faster than was forecast. That is also why the RBA should hike interest rates  at their May meeting. 

When the facts change

While the RBA did strongly signal that they were going to wait till June, these types of guidance are always conditional. As the emergency meetings in March 2020 and the ending of yield curve control in 2021 show when the facts change the RBA can swiftly change policy to match - even if that breaks with previous guidance or forecasts.

Rising rates directly after an increase in inflation instead sends an unambiguous signal that monetary policy will respond to changes in inflation. This both fulfills the RBA’s mandate for monetary policy and helps keep inflation expectations in check.

Waiting for official wages data is now redundant, indeed I'm sure the RBA’s extensive liaison program has already give them a fair idea of the pick up in wages that occurred in the first quarter of 2022.

The only thing that might nudge them into holding off would be the federal election itself.  The RBA is loathed to be seen to interfere in domestic politics for good reason, but the decision to avoid taking action is just as political as acting.

The RBA has both the means and the motive to hike interest rates on Tuesday, they should be prepared to pull the trigger.