Economists split between 25 or 40-bp rate hike

The Reserve Bank of Australia (RBA) board is set to deliberate on where the cash rate will sit for the month of June, during its monetary policy meeting this afternoon (7 June).

The decision will follow on from the 25-bp rise that took place in May, the first upwards movement for the cash rate in more than a decade that increased it from a record low of 0.1 per cent to 0.35 per cent.

But economists have tipped that it is not a matter of whether the RBA will choose to again raise the rate for June, but how large the increase is.

As a recent research note from CBA head of Australian economics Gareth Aird explained, there is a “universal agreement amongst economists and market participants that the RBA will deliver a rate hike”.

“As such, the focus for market participants is very much on the size of the expected hike,” Mr Aird wrote.

“And the debate is essentially centred on two potential outcomes; a 25bp rate hike or a 40bp increase in the cash rate.”

The RBA revealed that it had considered three options for the size of the rate hike in May: 15 bps, 25 bps and 40 bps.

The minutes for the monetary policy meeting showed the board believed the smallest option would not be effective enough to combat the ongoing rise in inflation.

Inflation had surged to 5.1 per cent for the year to March, while underlying inflation hit 3.7 per cent – far ahead of the RBA’s annual inflation target range of 2-3 per cent.

In that sense, the RBA board thought the 40-bp climb could be justified, especially with the rate at an ultra-low level.

But it had chosen to go with 25 bps, in line with its previous behaviour, with a “business as usual” approach.

As the 15-bp hike had been dismissed easily in May, Mr Aird does not believe the RBA will consider it today (7 June).

So that again leaves the two larger options, of 25 bps or 40 bps.

However, unlike his peers at ANZ and Westpac, Mr Aird has assigned a 75 per cent probability to a 25-bp outcome, pointing to a new government and recent data around wages, the labour force and national accounts.

Recent wage price index data showed wages growth recently slightly increased to 2.4 per cent for the year to March, compared to the previous quarter’s annual growth rate of 2.3 per cent.

As Mr Aird noted, the economy is moving higher and some people are receiving pay rises, but there are “not broad based wage pressures”.

“The RBA is not facing a wage-price spiral like is being observed in some other jurisdictions,” Mr Aird wrote.

“Put another way, the RBA does not have to run hard against wages growth by aggressively hiking the cash rate. Indeed the RBA wants to see wages growth continue to lift.”

The central bank has previously indicated that it would like annual wages growth to surpass 3 per cent, in order to sustain its inflation target range of 2-3 per cent.

Further, Mr Aird believes that the recent change of government will support a 25-bp uptick rather than 40 bps, as the RBA strives to remain apolitical.

“The optics of delivering a larger than 25bp increase in the cash rate in June might imply that the RBA board has changed their assessment of the outlook for inflation and/or inflation risks based on the change of government (recall that the 25bp increase in the cash rate at the May board meeting preceded the election),” the CBA report stated.

“That is not a message we believe the RBA would want to send. Indeed we do not think that the board will change their assessment on the outlook for inflation because of a change in government.”

Similarly, NAB economists have leaned towards a 25-bp increase, referring to the RBA’s previous “business as usual” approach.

However, it noted that there is still the risk of a greater front-loading in the hike cycle, especially as the US Federal Reserve, Reserve Bank of New Zealand and Bank of Canada have all recently chosen 50-bp increments.

The case for 40 bps

However, economists at ANZ and Westpac have referred to the RBA using wages data beyond the wage price index such as its own business liaison, in its decision-making.

As such, they believe there are signs that workers’ pay is growing at a faster pace than indicated by the index, which should convince the RBA to bump up the cash rate higher and faster.

CBA has assigned a 25 per cent probability to a 40-bp hike taking place for June.

Mr Aird also noted that a 40-bp hike would normalise the cash rate sooner, which could be argued for, but “an extra 15 bps does not shift the dial on the inflation outlook in any material sense”.

“Instead it simply risks putting undue angst into a household sector where consumer confidence is brittle,” he wrote.

He also added that many households that took out loans over the course of the pandemic had taken the RBA’s previous guidance at face value, when it suggested 2024 would be the earliest for a cash rate increase.

“These households might be left feeling very uneasy about the future if after a ‘business as usual’ 25bp hike in May (that they did not anticipate) the RBA then delivers a larger ‘business not as usual’ hike the following meeting,” he warned.

Further, the CBA analysis noted the impact for house prices, as they have begun to slip over May.

While the RBA does not account for housing in its mandate, it is aware of the links between house prices, consumer sentiment, spending and financial stability, Mr Aird stated.

“Pushing rates too high too quickly runs the risk of home prices correcting sharply lower in the near term which would have a ripple effect through the economy,” he wrote.

“A much preferable outcome is for home prices to adjust lower in an orderly manner which would be less problematic for the broader economy.”

CBA has forecast that the cash rate will hit 1.35 per cent by the end of the year, before continuing on to 1.6 per cent in early 2023.

[Related: ANZ predicts 40-bp cash rate hike for June]