Can the RBA be patient with inflation?

Pendal

June 2024

THE release of May's monthly CPI data showed the annual inflation rate flatlining at around 4%. Excluding volatile items, it has - in fact - nudged higher this year.

The word for inflation that springs to mind is stubborn. Too many items are significantly above the comfort zone.

Rents are 7.4%, insurance is 7.8%, and new housing construction and education are above 5%. Even tradables have picked up above 1%.

The higher monthly result was quite broad-based, though international travel had the biggest upside miss.

Underlying inflation is likely to print around 1%, which annualises at 4%. The RBA itself was expecting 3.8%.

You can see why many in the market are now calling for an August rate hike, though I'm not sure a 0.2% miss warrants another rate hike.

It's what the RBA thinks that is important.

All eyes will now turn to the Q2 numbers out at the end of July, just before the RBA's August meeting.

If our central bank can be patient, good news is at hand.

Subsidies will see inflation in Q3 nearer to 0.4% headline and 0.8% underlying. Recent minimum wage outcomes also point to wage relief.

While subsidies are temporary, and therefore dismissed by many, the second-round impacts are important. I also suspect the subsidies will be a more permanent feature in the transition economy.

Is this November all over again?

As the new RBA Governor, Michelle Bullock came in swinging on inflation last year - stating a low tolerance for upside surprises.

However, the Q3 inflation numbers surprised by 0.2%, putting the RBA in a corner and forcing it to hike in November.

Bullock has since avoided that phrase, now referring to vigilance on inflation. This leaves some optionality but will make the discussion at the August meeting very interesting.

It would be a brave call to hike.

The last time the RBA went against the global picture by hiking was in February and March 2008, which turned out to be major errors; there is usually some safety in the pack.

I think, given the international context where other central banks are cutting or leaning towards cuts, the RBA will sit out August and leave rates unchanged. This may be a close call.

The RBA currently expects trimmed mean (underlying) inflation to be 3.4% by year's end. If we get another 1% in Q2 as we saw in Q1, it means the final two quarters will need to average 0.7%.

The second-round impact of subsidies may help the cause, but it will be a challenge.

What if the RBA does hike?

Politically, the government is hoping to fight the next election on cost-of-living relief and the Stage 3 tax cuts.

A rate hike would wipe out any feel-good impact from the electorate and put Governor Bullock on the front page like her predecessor.

This won't stop her from hiking if needed, but if the case is not clear, caution may prevail.

A hike would only repeat what has gone on over the last 12 months.

Retirees and wealthy people get richer, younger middle Australia gets whacked again, and everyone sits around scratching their heads as to why rents and insurance - the prices of which move up, not down with rates - aren't helping.

What about markets?

Markets have moved the odds of an August hike from around 20% to 60%.

Three-year yields are again above 4% (up 15 basis points) and ten-year yields are at 4.3% (up 10 basis points).

We will look for the odds to improve before leaning against these moves.

While we don't expect a hike, it is not a confident view - meaning, entry levels are important.

For now, our duration remains at - or near - benchmark as we knew Q2 inflation would always be a hurdle markets would need to clear before a more significant rally later in the year.

Author: Tim Hext

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