‘Sequence of surprises’ tipped to push interest rates higher

The resilience of the economy and recent moves by the RBA has led some economists to revise their previous interest rate predictions.

NAB Group Economics has reverted back to its baseline expectation from February that the cash rate will rise to a peak of 4.1 per cent by July, following “a sequence of surprises from the RBA in recent months”.

“Our February call of a likely 4.1 per cent peak in the cash rate was based on three fundamentals: that inflation would remain well above target in the near term; that the economy was displaying considerable resilience; and that a tight labour market would continue to support a pickup in wage growth. These fundamentals all remain evident,” NAB said in its Monetary Policy Update.

NAB stated that strong population growth and rebounding services consumption are continuing to support the economy despite the growing pressure from higher interest rates and inflation on consumer spending.

“Conditions in the NAB Business Survey are easing but remained well above average as of and capacity utilisation is very high,” it said.

Strong employment growth is also strengthening the resilience of the economy with the unemployment rate hovering at very low levels since mid 2022.

“This is supporting incomes with hourly wage growth already running at over 3 per cent in 2022 and set to strengthen this year, with additional wage pressure likely to come from ongoing tightness in the labour market as well as the next minimum and award wage increase,” it said.

“There are some signs that consumption is softening, including recent soft readings in NAB’s internal transaction data. This is consistent with our expectation that the economy will slow this year as higher rates weigh on households.”

AMP is expecting interest rates will remain on hold from this point, however.

Internal RBA documents released last week indicate that a cash rate as high as 4.8 per cent would not trigger an economic downturn and would only push the unemployment rate to 4.5 per cent.

AMP deputy chief economist Diana Mousina said while this could be a hawkish sign from the RBA, “upcoming economic data will disappoint expectations, as impacts of rate hikes start to bite and as inflation slows faster than forecast”.

Outlook for inflation

The Reserve Bank has forecast inflation to slow from its current 7 per cent year on year to 4.5 per cent by the end of 2023, before reaching 3 per cent by June 2025.

“[This implies] a further two year of above-target inflation. These forecasts were based on an assumed interest rate peak of around the current 3.85 per cent,” said NAB.

A large part of the near-term moderation is expected to come from easing global goods inflation, as well as easing building costs.

“However, achieving further progress towards the target in 2024 and 2025 will depend on the services side where the outlook for wages growth, inflation expectations and the resilience of demand will be increasingly important,” the NAB update stated.

“For now, inflation expectations remain reasonably well anchored. On wages, we expect hourly wage growth to rise as high as 4 per cent y/y across 2022, before softening as the economy slows and labour market pressures ease. However, there is considerable uncertainty around these forecasts.”

NAB stated that having inflation above target for a further two years is likely the very limit of what the board would consider a “reasonable timeframe”.

“Indeed, given the recent RBA Review recommended the Board focus on achieving the mid-point of the target (2.5 per cent), it may be that reaching only 3 per cent by the end of the forecast period is outside what is reasonable,” it said.

“On this basis, the cash rate would need to be higher than the current level to ensure inflation moderates sufficiently quickly, especially if there are any unwanted surprises on the wages front.”

A cash rate of 4.1 per cent would be in “restrictive territory” and would have a material impact on household cash flow, the bank said.

“However, assessing the restrictiveness of monetary policy in real time is difficult, and it is a real possibility that an even higher cash rate of 4.35 per cent is necessary to balance the risks on inflation,” it said.

“For now, we see a rate peak of 4.1 per cent as most likely, including because of the RBA’s signalled willingness to tolerate a more gradual return to target inflation.”

Leaving rates on hold at 3.85 per cent could leave the RBA exposed to considerable risk if the economy is more resilient, wages more response or services inflation stickier than expected, NAB said.

As higher rates pass through to household cash flows and the wider economy, NAB expects the economy will slow noticeably in the second half of 2023 and into 2024, with annual GDP growth below 1 per cent and the unemployment rate to rise, reaching around 4.7 per cent in 2024.

“We continue to expect the cash rate to return to a more neutral rate as this slowdown takes hold. Our view is that neutral should involve a small positive real rate. That could be a cash rate of around 3 per cent in nominal terms and we expect to see the RBA cutting to around this level from mid-2024.”

Rate pause likely for June board meeting

A pause is the most likely outcome for the June RBA board meeting, according to NAB economists.

“Since April the RBA has shown a preference to move away from monthly moves and accumulate data over larger intervals given it is now a matter of fine-tuning how restrictive policy is under heightened uncertainty,” it said.

However, if the wage price index (WPI) released this week exceeds expectations, a further rate increase to 4.1 per cent could come as soon as the next board meeting in June.

NAB said a 25 bp rise will likely come in July instead, when the RBA will have the benefit of both the Q1 WPI and National Accounts releases as well as additional labour force and monthly CPI indicator prints and the National Wage Case decision.

“Indeed, the Board may choose to hold off on further moves until August, when it will be armed with the full Q2 CPI release and another round of staff updates,” it said.

“As we have previously said, the longer the RBA chooses to wait the more likely they will begin to see evidence of slowing activity, which may limit the impetus for rates to rise. However, as demonstrated by recent RBA staff scenario exercises revealed through FOI, the trade-off for keeping rates lower is likely to be that rates need to remain restrictive for longer – an outcome the Board would want to avoid.”