Over the past week or so, you’ve probably heard a fair bit about fixed–rate home loans from some banks being adjusted down. Not unsurprising, given cash rate forecasts in a couple of years are lower than the current 4.35%.
That is usually an indication that the banks view the effective rate over a period as lower than their fixed rate had been, or, for balance-sheet reasons, are trying to secure business.
Combined with this, ANZ, NAB and CBA economists have forecast that the next RBA rate change will be down, not up.
Although Westpac's economics team still sees an increase as its next move, it expects easing in the future.
Australia’s big four banks are now divided about the path ahead.
None of the major banks expect these movements to happen when the RBA board makes its cash rate decision on Tuesday.
If you look at Australia’s bond market, traders are pricing yields lower than a few weeks ago because of softer growth and lower-than-expected inflation data.
This is normally where a politician would make the joke to support their views, quoting economist Edgar Fiedler, “Ask five economists and you’ll get five different answers”.
Which, in this case, is probably true.
That’s because predicting the future is hard. An economy is a complex system with a high degree of randomness, captured by aggregated metrics.
But that isn’t the main reason for the divergence in forward-looking views; it also comes down to a difference in opinion among banks, forecasters and traders about what the RBA’s role is in a supply-side shock, particularly an oil shock.
In general, where the difference lies, there are two main camps: one in which isolated oil supply shocks should be just that and don’t warrant a monetary policy response. Usually, this camp thinks that the interest rate role is only ever about the aggregate demand side of the economy.
The other camp is that oil supply shocks should warrant some RBA response to dampen inflation expectations. This group tends to view the role of interest rates as more holistic, accounting for inflation expectations and the equilibrium of aggregate supply and demand.
Aggregate demand camp
Let’s focus on the aggregate-demand-only camp first.
When interest rates change, they mostly, at least in the short term, affect the demand side of the economy: rates go down, demand increases, inflation rises; or rates go up, demand decreases, inflation falls.
Because of this relationship, this camp tends to believe that increasing rates, as a supply-side oil shock occurs, is a double hit to growth for oil-importing nations like Australia.
Spikes in oil prices tend to dampen demand. However, oil is quite an inelastic product, meaning demand isn’t overly responsive to price changes, unlike elastic goods like flights.
Large oil tanker ship smoking sails Strait of Hormuz, Persian Gulf, Iran. Picture: Getty
That is a fair argument, one that most forecasts have moved toward, particularly as the war in Iran is supposedly almost over, and the Strait continues to be “open”, though World Trade Organisation data would disagree.
Where the double hit to growth for oil-importing nations’ argument can fall down in Australia’s context is that we are unique when it comes to energy: we export a lot of energy, coal and gas, with about a 3-to-1 energy export-to-import ratio. That means oil price shocks can actually strengthen our net exports thanks to increased demand for other energy commodities and exchange rate protection.
Until this point, the price growth in non-oil energy commodities hasn’t been as strong as probably would have been expected when the war broke out. But that is also true for oil.
Optimism (or world leader tweeting) seems to be keeping those prices down.
Additionally, our currency has appreciated against the US dollar since the start of the year, not depreciated.
Meaning that our export industries haven’t been able to offset the negative shock to households and firms.
Hence, growth has been a bit softer.
Pushing the aggregate demand camp to say that, once the domestic inflationary pressures are suppressed from holding rates steady, then the RBA should cut.
The RBA has a difficult job on its hands with high inflation and low growth. Picture: Hu Jingchen/Xinhua via Getty Images
Inflation expectations camp
The inflation expectations camp doesn’t disagree with this cut, at least in the future, but thinks there is a need to dampen inflationary expectations further in the near-term before doing so.
RBA research shows that consumers feel price rises at the petrol pump more than other goods.
That is, consumers’ future expectations of price increases are more sensitive to fuel price movements than they are to changes in other prices.
We saw this spike when the oil shock first occurred, with inflation expectations reaching a higher level than at any point in 2022.
Inflation expectations have since come down, due to policy responses, softening growth and flattening oil prices, but remain quite elevated.
The reason the expectations camp worries so much about inflation is that price rises become self-fulfilling. If households and businesses expect costs to increase, they bring forward spending, whilst simultaneously households will demand higher wages, and businesses will increase selling prices.
This is called the wage-price spiral, driving greater inflation.
Soaring petrol prices are acting like a “hidden” rate hike, quietly draining household budgets before any official RBA move. Picture: NewsWire / Luis Enrique Ascui
We saw an example of this recently when the minimum wage was increased by 4.75%. Mostly due to headline inflation forecasts for the end of the financial year. Near inflation, but below worker demands for 6%.
Not to say that minimum wage increases aren’t important, and there is a balancing act here, but if inflationary expectations were lower, workers’ demands would be lower, and inflation would hopefully be transitory.
To lower those inflation expectations, the RBA needs to do what it calls inflation expectation anchoring. Anchoring is where the cash rate is used to fix household and firm long-run inflation expectations towards the target band (2-3%) by increasing the cost of money now, so that behaviours shift and spending reduces.
Westpac, at least currently, thinks that, because of higher inflation expectations in the economy and the relative stickiness of inflation, further rate increases are required.
At the last board meeting, the RBA thought the same.
Who will win?
My view remains that Westpac and the inflation-expectations camp are more on the money than the aggregate-demand camp. Given the recent and prolonged stickiness in domestic inflationary pressures, combined with higher expectations, the RBA can't let inflation get away from them again.
The market still thinks that a hike is more likely than not, though only just, meaning that the expectations camp will be more likely to win this argument by the end of the year, with one more hike.
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