Reserve Bank expects to lift rates to 2.5%

The Reserve Bank (RBA) Governor delivered a speech: “Inflation, Productivity and the Future of Money”.

In response to a question the Reserve Bank Governor noted “…we have more interest rate increases to come. Two-and a half per cent is our rough estimate of the neutral rate. At some point I imagine that rates will get to at least that level. How quickly we need to get there and indeed whether we need to get there will be determined by the inflation outlook.”

Federal Treasurer Jim Chalmers has today announced the terms of a wide-ranging review of the RBA, focusing on its inflation target, policy tools, governance and culture. A set of recommendations from an independent three-person panel is expected to be provided to the Albanese Government before March 2023.

What does it all mean?

The Reserve Bank Governor has intimated a goal of lifting the cash rate to 2.5 per cent. That is the RBAs rough estimate of the “neutral” cash rate in nominal terms – the rate that is neither slowing down the economy nor speeding it up. At the current 1.35 per cent, the cash rate is stimulating the economy – at a time of high inflation and a tight job market. Governor Lowe said, “The policy challenge for the RBA is to return inflation to the 2-3 per cent target range, while, at the same time, keeping the economy on an even keel.”

While 2.5 per cent has been specified as the broad target for the cash rate, the RBA Governor says that rates are not on a pre-set path: “How quickly we need to get there and indeed whether we need to get there will be determined by the inflation outlook.”

Commonwealth Bank (CBA) Group economists tip 50 basis point (bp) rate hikes in August and September and a 25bp move in November, lifting the cash rate to 2.6 per cent, broadly in-line with the RBA’s “neutral” cash rate. But money market traders are pricing in a 3.5 per cent cash rate by December, fuelling fears about a potential economic slowdown.

The RBA Governor has delivered a warning on wage and price setting. “If people setting prices and wages were to believe that higher inflation will persist, they are more likely to push prices and wages up. This could result in a selfreinforcing cycle: one in which higher inflation leads to firms being more willing to put their prices up and agree to larger wage claims, which then perpetuates the higher rate of inflation, and the cycle repeats itself. This is what happened in the 1970s and it ended badly.”

The good news is that the Reserve Bank Governor says this is not happening, at least not yet. “There is little evidence of such a cycle at present and it is important that this remains the case. The RBA is committed to ensuring that the current period of higher inflation is only temporary and it will do what is necessary to bring inflation back to target. It will be harder to do this if the inflation psychology
shifts.”

The Reserve Bank Governor has highlighted that inflation psychology, the reaction of households and productivity are key issues in setting interest rates and how the inflation rate evolves.

The Reserve Bank Governor has welcomed today’s announcement of a review of the Bank’s operations.

Originally published by Craig James, Chief Economist, CommSec