Is the RBA’s cycle over?

After a record 350 basis points of rate increases, the Reserve Bank of Australia has prudently chosen to pause the monetary policy tightening cycle at a target cash rate of 3.6 per cent, precisely the level at which its own internal analysis suggests that about 15 per cent of all Aussie borrowers would face negative cash flows.

Most hope that this is the end of the cycle, which it could easily be. The bond markets certainly believe that to be the case, with the RBA cash rate expected to be 25 basis points lower by December. It’s a similar story in the US where the bond market is pricing in only half of one future interest rate increase from the Federal Reserve and then projects that it will cut by about 100 basis points by January.

It’s worth thinking through, however, the counterfactual case where the market is wrong. And that would involve central banks pausing for a period and then embarking on another tightening cycle.

This is, in fact, extremely common. The RBA’s past two tightening cycles were punctuated by pauses. Between 2009 and 2010, the RBA lifted its cash rate from 3 per cent to 4.75 per cent, which was extended by a pause over five consecutive meetings between May and November 2010.

In the much more protracted cycle between 2002 and 2008, which involved Martin Place raising rates from 4.25 per cent to 7.25 per cent, there were very long pauses, including three elongated windows that persisted for 12 months or more.

With global corporate defaults already rising at the fastest pace since 2009, local business insolvencies spiking and mortgage arrears reported by non-bank lenders climbing sharply, a second tightening cycle would be diabolical for individuals and companies that had predicated their finances on the low-rates-for-long paradigm.

Every day we read or hear about new cracks opening up across the economy. Residential property developers, commercial property owners, builders, interest rate-sensitive industries and some non-bank lenders that funded them on excessively loose terms are all in strife.

The case for further increases

What then are the arguments in favour of central banks pausing for a period and then proceeding to lift rates again? The first is that past monetary policy tightening cycles have involved restrictive interest rate settings and a sharp increase in the unemployment rate to levels materially above estimates of full-employment, known as the “non-accelerating inflation rate of unemployment” (NAIRU).

Yet in this cycle some, including Coolabah’s chief macro strategist Kieran Davies, argue that the RBA’s cash rate of 3.6 per cent “is only slightly above its neutral nominal cash rate of 3.5 per cent”. “This assumes the RBA credibly anchors inflation at the 2.5 per cent midpoint of its 2-3 per cent target range,” Davies says. Put differently, policy is not actually that tight according to this perspective.

At the same time, most observers agree Australia’s unemployment rate of 3.5 per cent is still well below the RBA’s judgment-based NAIRU in the low 4 per cent range and its modelled estimates in excess of 5 per cent.

And while underlying inflation has peaked and eased during the first quarter of 2023, which could result in the RBA extending its pause next month, it is still forecast by the central bank to be above its 2-3 per cent target band until 2025. This in turn raises the spectre of actual inflation feeding back into higher expected inflation, which could entrench a wage-price spiral.

This risk is compounded by the possibility that wage growth could accelerate further this year. It is widely anticipated that the Fair Work Commission will deliver another large increase in the minimum wage. The largest state governments are also relaxing their wage caps.

Here Davies notes that “nominal unit labour costs – which feed into the RBA’s models of inflation and represent labour costs less productivity – are already growing strongly given higher wages and weak productivity”.

The RBA touched on this point in its press release during the week, highlighting that current wages growth would only be “consistent with the inflation target … provided that productivity growth picks up”.

An important mitigant here is record migration growth, which is providing a positive labour supply shock and ameliorating the human capital shortages that have plagued the economy since the pandemic.

Australia is an immigration nation, with about one-third of our residents born overseas. The strongest migration-fuelled population growth in the OECD has been a key driver of the miraculous performance of the Aussie economy since the deep, inflation-induced recession experienced in the early 1990s.

Household savings risk

There is one final risk to the idea that the RBA’s tightening cycle is over – the huge excess cash savings that have been hoarded by households. I explained last week that we estimate that this is equivalent to about 20 per cent of annual household income and is one reason why demand and spending have been so resilient in the face of record interest rate increases.

New research undertaken by Davies shows that Australia’s pool of excess savings is actually much larger than that built up in either the US or Europe, regardless of whether it is expressed as a share of household income or GDP. If households tap this pool of savings to prop up spending, it might prove harder to tame inflation locally without even more aggressive action by both fiscal and monetary authorities.

First published in the AFR.