Forecasting how high central banks will lift official interest rates in the current cycle is proving to be an unusually difficult task. One problem is judging whether central banks will be as good as their current word and do whatever it takes to reduce high inflation back to target inflation over time, or will they buckle as demand growth slows under pressure from higher interest rates? Another problem is trying to determine the peak in the current high inflation rate and then how it subsides and whether it eventually bottoms out above, at or within the targets set by central banks. Neither of these problems has a clear answer yet and as a result the summit for official cash rates remains clouded.
What can be assessed with some degree of certainty is that the peak for the US Fed’s funds rate, currently at 2.50%, will be higher than the peak for the RBA’s cash rate, currently at 2.35%. While it is still tough forecasting the peaks in US and Australian inflation and the troughs a year or two beyond, it is highly likely that US inflation will be higher and stickier than Australian inflation because of relatively tighter labour market conditions and higher wage growth in the US than Australia. Also, the Fed is aiming for 2% inflation over time against inflation inside 2% to 3% target range for the RBA.
Over the next fortnight or so the Fed and RBA hold their rate setting meetings. A higher-than-expected US August CPI reading, +0.1% m-o-m, +8.3% y-o-y, concentrated in the core CPI reading, +0.6% m-o-m, +6.3% y-o-y implies that the Fed is still well behind the curve fighting inflation and needs to deliver another big rate hike of 75bps or even 100bps taking the Fed funds rate up to 3.25% or 3.50%. Even then, the Fed’s rate-hiking work will be far from done and analysts until recently forecasting a Fed Funds rate peak near 4% in 2023 are migrating towards 5% and possibly higher.
The course of US inflation will determine how high the Funds rate needs to go and how high it will need to stay longer term. While there are forces in play starting to drive down inflation from its current heights including statistical base effect from high monthly CPI increases a year ago, moderating demand for goods, improving supply chains, lower gasoline prices and the strong US dollar, there are also forces still supporting high inflation including the acute US housing shortage and escalating rents, strong demand for services and the tight labour market. The Fed and financial market analysts expecting moderating annual inflation over the next few months can still be blind-sided by rogue monthly CPI readings, as they were by the August CPI.
In Australia, the annual CPI inflation rate looks set to peak either in Q3 or Q4 and probably close to latest official forecasts around 7.8%. Beyond the inflation peak it is the pace of moderation that is becoming less clear. Other than for home purchase, demand is holding up in the face of interest rate increases so far. Demand for services is especially strong adding to tight labour market pressure. Wage demands are lifting with annual increases above 4% becoming more common. Wage growth is on the cusp of becoming a factor threatening to prevent annual inflation from returning to the RBA’s 2-3% target range over the next two or three years.
In the near term, big increases in household energy costs and housing rents will work towards holding the annual inflation rate high. Over the late spring and summer months another La Nina weather event threatens flooding rains again over Eastern Australia and renewed escalation in food prices. So far, high inflation has not fed through to higher inflation expectations in financial market pricing, but the longer inflation stays comparatively high the greater the risk that inflation expectations start to rise.
A lower Australian inflation peak than the US, still less wage pressure than in the US and well-anchored Australian inflation expectations have meant that the RBA does not need to lift its official interest rate as high as the Fed may need to. Until recently, these factors have also allowed the RBA to consider that it may need to lift the cash rate only to neutral setting in 2.50% to 3.00% range. The RBA seems to be adjusting its consideration, recognising that high inflation pressure may prove to be stickier for longer than it was forecasting previously.
RBA Governor, Philip Lowe, in parliamentary testimony last week and under questioning indicated that the cash rate would need to rise to at least 3% and stay around 3% for some time. He also indicated that at the early October policy meeting there will be a fifth consecutive rate hike with the only issue of contention whether it should be 25bps to 2.60%, or 50bps to 2.85%.
RBA guidance around official rate changes has been a moving feast over the past year from no alteration before 2024 of the low 0.10% cash rate prevailing in late 2021 and early 2022 to support recovery to the need to lift the cash rate quickly to near neutral setting to batten down inflation. The much greater difficulty forecasting inflation with any confidence imply RBA rate guidance will continue to shift.
Over the past year, some of the factors igniting inflation and leading to the extraordinary shift in rate guidance could not have been foreseen such as Russia’s Ukraine invasion causing spikes in food and energy prices, or the course of the Covid pandemic with big cuts in demand followed by sharp rises.
While these extraordinary factors and their impact on inflation could not have been forecast in advance, as they started to appear through 2021 and in early 2022 they should have prompted central banks to consider that the models they used to forecast inflation based on past experience of the cycles over the past decade and more were likely to start substantially underestimating inflation. The persistence of low central bank inflation forecasts in 2021 and early 2022 fostered the delay in starting to lift official interest rates leaving the central banks, including the RBA, chasing an inflation problem that has got away from them.
Our latest forecasts of the RBA’s cash rate are a 50bps rate hike in early October to 2.85%. The Q3 CPI release in late October will set the scene for what happens in early November, probably a 25bps rate hike to 3.10%. We see further rate hikes beyond taking the cash rate up to 3.60% early in 2023. That may be the peak, but we not confident. The cash rate summit is still very much clouded at this point by the still hard to predict conflicting forces shaping inflation and inflation expectations over the next few months.