The Reserve Bank (RBA) Board has lifted the cash rate by 50 basis points (half of a percent) for a second straight month, taking the cash rate to 1.35 per cent. This represents the biggest back-to-back rate hikes since the cash rate was first targeted in 1990. The RBA increased the interest rate on Exchange Settlement balances from 50 basis points to 1.25 per cent.

The Board said that it “is committed to doing what is necessary to ensure that inflation in Australia returns to target over time.”

What does it all mean?

There are two important points to consider when evaluating the latest Reserve Bank decision to lift interest rates. The first, is that rate hikes are happening across the globe. Nearly all central banks across the globe are lifting rates from ‘emergency’ levels to reflect more ‘normal’ functioning economies. The second point is that rates are being lifted to slow down economies and bring supply (production) and demand (spending) back into balance to address soaring inflation rates.

Central banks are ‘front loading’ rate hikes to try and get on top of inflationary pressures. That is, rates are being lifted quicker and more aggressively than usual. The fear is that if higher rates of inflation take hold – become cemented in people’s consciousness – then it will take longer to bring the inflation rates back to preferred levels.

One factor driving inflation higher is Covid-19. Workers are continuing to contract the virus and forced to stay at home, resulting in fewer goods and services being produced. But economies are continuing to recover from the virus, with spending lifting. Unfortunately spending is recovering more quickly than production.

The other key factor is the war in Ukraine, driving up energy and food prices across the globe.

The risk with ‘harder and faster’ rate hikes is that they could cause economies to go into recession. Recessions are differently defined across the globe, but in Australia the general definition of recession is two consecutive quarters of economic contraction (declines in gross domestic product).

Commonwealth Bank (CBA) Group economists expect the cash rate to rise further in coming months: a rate hike of at least 25bp is expected in August, then 25bp moves in September and November, taking the cash rate to 2.10 per cent by year-end. The risk is that rates rise a little higher than currently expected, to 2.35 per cent.

Commonwealth Bank (CBA) Group economists expect the Australian economy to slow, not stall. In calendar 2022 the economy is tipped to grow by 3.5 per cent and then grow a further 2.1 per cent in calendar 2023.

The assessment

On the inflation challenge, the Reserve Bank expresses some confidence: “Inflation is forecast to peak later this year and then decline back towards the 2–3 per cent range next year.” Further the RBA notes “Medium-term inflation expectations remain well anchored and it is important that this remains the case.”

On wage pressures the Reserve Bank said: “The Bank’s business liaison program and business surveys continue to point to a lift in wages growth from the low rates of recent years as firms compete for staff in the tight labour market.”

Perspectives on interest rates

The RBA lifted the cash rate by 50 basis points (bp) or half a per cent to 1.35 per cent. This follows a 50bp increase on June 7 and a 25bp increase on May 3, 2022. The RBA last cut the cash rate from 0.25 per cent to 0.10 per cent on November 3, 2020. Before the Covid-19 health and economic crisis, the official cash rate was 0.75 per cent on February 5, 2020.

Implications

Higher borrowing costs should lead to slower demand for houses. But as home prices ease, they will actually become more affordable for home buyers – especially those buyers with higher deposits or greater equity.

Higher interest rates are also positive for savers. It’s important to remember that household deposits have risen 28 per cent or $283 billion since Covid hit in February 2022. If the 50bp rate is fully passed on, it will add more than $6.4 billion to household incomes – providing a welcome boost especially to the incomes of retirees.

Published by Craig James, Chief Economist, CommSec