Why the Review is going to lead to higher interest rates

By the end of year and perhaps sooner...

Many journalists have framed the question of the review in terms of its implications for the average Australian household, particularly concerning their mortgage repayments.

Most commentators have focused on the change in the frequency of meetings. Reducing the number of meetings from 11 to 8 per year will result in fewer changes that households need to factor into their planning, but these changes might be of a potentially larger magnitude. However, the impact of the review extends well beyond this superficial alteration.

At a broader level, I expect that an improved policy process at the RBA will lead to a decreased likelihood of recessions or inflationary booms in the future. Both are detrimental, as we have recently experienced, and any change in the policy process that reduces their frequency should be celebrated.

But upon further reflection, I believe that the Review has directly increased the likelihood of higher interest rates.

Sprinting down the narrow path

The current monetary policy approach aims to navigate the “narrow path” back to normality. Presently, this path is expected to include two years of high inflation above the target, followed by a return to the top of the target band around mid-2025. This plan by the current board aims to balance disinflating the economy while preserving the employment gains made over the past two years.

However one of the less-discussed recommendation (2.1 to be precise), though one I wholeheartedly support, is the re-focusing of the target from anywhere within the 2% to 3% range to a target with an emphasis of aiming for the midpoint of 2.5% over the medium term.

How would this “refocusing” be operationalized in practice? A straightforward interpretation is that the RBA should set policy such that they forecast rate of inflation to 2.5% at the end of the forecast horizon (which is currently mid 2025).

This does not describe the current policy approach; aiming for 3% is a substantively different outcome to aiming for 2.5% by mid-2025 and would require a significant tightening of monetary policy to achieve.

Of course this change to the framework has not yet been implemented. The RBA's monetary policy will be updated sometime in the second half of this year when the Statement on the Conduct of Monetary Policy is reset. At that point, the current approach aiming for the top of the target band will no longer align with the RBA's mandate.

If the board follows the mandate provided by the democratically elected government, they will be compelled to adopt a tighter monetary policy. This will involve more interest rate hikes and maintaining higher rates for a longer period to bring inflation back to 2.5% instead of 3%.

While the switch to focusing on the midpoint of the target band will only officially take effect when the Statement on the Conduct of Monetary Policy is rewritten a case can be made for the RBA to adopt this approach today. Given that both political parties have embraced all review recommendations it would not be unreasonable for the RBA to switch to a midpoint-focused approach today. This would necessitate a tighter path for interest rates over the next few meetings and likely involve at least another 100 basis points of interest rate increases when we might have otherwise seen only one or none.

While this might not have been the government's intention, the review will likely result in higher interest rates in the medium term and possibly even higher rates as soon as next May if the RBA is serious about reaching an inflation rate of 2.5 per cent anytime soon.