What the smartest rates strategist on the street thinks about RBA

The best rates strategist on the street, Barrenjoey's Andrew Lilley, has recently published another thought provoking piece on the RBA's reaction function. While I am constrained with respect to what I can extract regarding his views, this brief summary will give you a sense of what he is thinking right now.

The first point is that Dr Lilley believes that the probability of future RBA rate hikes is "drastically underpriced" even if he handicaps the likelihood of one today at just 25% (this rises to 40% by August). A second key observation is that the RBA is facing a forecast surprise on both its inflation and unemployment projections that is so large that it should not hesitate to consider hiking. To quote Lilley:

The combined forecast surprise across inflation and unemployment is statistically around a 96th percentile outcome versus their forecasts – if this were not enough to hike, it is hard to imagine what type of surprise be necessary.

A third insight is that Aussie government subsidies across rents, childcare, electricity, and preschool have artificially pushed measured inflation down from 4.2% to 3.6%. Excluding these subsidies, Lilley finds that core inflation in Australia has been consistently running at 3.6% pa for the last three quarters. Underlying inflation is, therefore, stabilising at a level way above the RBA's 2.5% target (and not mean-reverting).

More worrying is the fact that Coolabah and Lilley's modelling both arrive at the same conclusion apropos the next June quarter inflation print: it should be high again at 0.9% or more, continuing the trend of well-above-target outcomes.

A fourth point is that Lilley models the countervailing impacts of home loans switching from fixed-rate to variable-rate balanced against the incoming tax cuts in July. The RBA estimates the fixed-rate roll-off is equivalent to a +30bps increase in mortgage rates by the end of 2024. Lilley computes that the tax cuts are worth about 107bps worth of extra mortgage rate cuts over the same period: 

The combination of monetary and fiscal policy delivers a substantial easing between now and the end of the year...This dwarfs the impact of the remaining fixed rate roll-off – it’s around as large as the whole “fixed rate cliff”, but it is a true cliff in the sense that the marginal effect to disposable incomes (+5bn/qtr) changes immediately, instead of over two years.

In RBA cash rate terms, the tax cuts are worth about two official 25bps cuts (not 107bps) because they only impact the household channel and not the broader macroeconomy. But there are still two full RBA cuts coming down the pike.

Lilley also finds that the change in market pricing for the RBA's cash rate track, and the removal of cuts this year, should not be enough to adjust the RBA's forecasts for inflation, and hitting its target band, in 2025. More substantively, he notes that the RBA has followed a very simple heuristic every time it has had an inflation shock of this magnitude:

The RBA has admittedly been most willing to tolerate higher inflation of the G10 central banks – but they have also followed a simple rule of thumb to a “T”- they have hiked every quarter where trimmed mean has printed above 0.9% [the March quarter printed above this at 1.0%] and held whenever it has printed at or below this level.