At her first Board meeting, Michele Bullock stuck to the script. Against the backdrop of a weak AUD and upward pressure on benchmark bond yields - making the battle against inflation more challenging, Governor Bullock decided to leave the cash rate steady at 4.10%, preferring to let the 4 percentage points of rate increases since May 2022 play its role in dampening inflation.
Last month’s CPI report (5.2%) was broadly in line with consensus, with a further easing in annual core inflation (5.6%), which would have comforted the board.
Meanwhile the Australian consumer appears to have run out of steam, Retail sales for August were up just 0.2% month-on-month (m/m) which was slightly below consensus expectations of +0.3%. Compared with August 2022, retail sales were up 1.5% year-on-year, which was below the rate of inflation (5.2%), meaning retail turnover was down in real terms.
So where to from here? Ahead of the announcement, the swap market had predicted one further 25bps rate rise by February 2024 and moving to rate cuts in 2H 2024. With core inflation (5.6%) still well ahead of Bank’s forecast of 4% by year-end, we do not expect today's decision to alter this outlook.
Our economist, Michael Knox, maintains the view that the RBA will need to track the US Federal Reserve given persistent underlying services inflation and the Australian inflation rate remains stubbornly higher than the US.
He expects the RBA to lift the cash rate three more times to 4.85% and remain at this level for much longer than the market expects - he anticipates the first rate cut in late 2024.
“We believe that the RBA will encounter the same problem in the Australian economy that the Fed is encountering in the US economy. Even though goods inflation is falling, wage inflation is beginning and will continue to rise. This means that falling inflation in goods will collide on the way down with services inflation coming up. The result in the US economy seems to be that core inflation first declines and then gets stuck at around 5%. We think it’s likely that Australia is going to encounter the same problem after a short lag to the US. Hence, we believe that further increases in the Australian cash rate will be necessary. We hold to our target that the Australian cash rate will continue to rise to a final level of 4.85%.” Economic Strategy: Rates to 4.85%, July 2023.
What does this mean for the Australian economy and markets?
Lags in the transmission of monetary policy through the economy mean that the full effects of the policy tightening over the preceding year are only now starting to show.
There remains considerable uncertainty about the resilience of household consumption and that the squeeze on many households’ finances could result in consumption slowing more sharply than implied by current forecasts. Higher interest rates could also be expected to encourage households to save more, which would affect consumption.
In our Q4 Asset Allocation update (Morgans Clients Only), we moved to underweight on Australian equities as we see ongoing volatility from high interest rates and a moderating pace of economic growth challenge returns in the short term. US fiscal policy is contracting, hitting commodities prices and curbing economic growth, further prolonged weakness in the AUD will continue to drive up cost pressure.
Given Australia’s economic sensitivity to falling commodity prices, investors must tread carefully over the next 3-6 months. As tailwinds from commodity prices fade, we think above-average earnings growth for the market will be harder to come by. Accordingly, we prefer a targeted portfolio approach, tilting what we believe are the best relative opportunities and the best risk/return profile e.g., small caps, quality cyclicals.
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