‘Further tightening may be required’, RBA warns

On Tuesday (2 May), the Reserve Bank of Australia (RBA) announced that it was increasing the cash rate by 25 bps to 3.85 per cent.

The move came as a surprise to many economists, who had expected that the lower-than-expected inflation figures (for the quarter ended March 2023) would have stayed the central bank’s hand this month.

In a statement following the monetary policy decision on Tuesday (2 May), RBA governor Philip Lowe reiterated that the bank’s target of reaching an inflation rate of between 2–3 per cent is still several years away, given that inflation is ‘still too high’.

While the RBA had decided to hold rates steady last month to “provide additional time to assess the state of the economy and the outlook” — including offset data — Mr Lowe said that even though there had been a “welcome decline” in inflation, the central forecast was still that it would be a couple of years before inflation returns to the top of the target range.

He continued: “Inflation in Australia has passed its peak, but at 7 per cent is still too high and it will be some time yet before it is back in the target range. Given the importance of returning inflation to target within a reasonable time frame, the board judged that a further increase in interest rates was warranted today.

“Inflation is expected to be 4.5 per cent in 2023 and 3 per cent in mid-2025…

“The board’s priority remains to return inflation to target. High inflation makes life difficult for people and damages the functioning of the economy. And if high inflation were to become entrenched in people’s expectations, it would be very costly to reduce later, involving even higher interest rates and a larger rise in unemployment.

“Medium-term inflation expectations remain well anchored, and it is important that this remains the case. 

“Today’s further adjustment in interest rates will help in this regard.”

What’s driving inflation?

Looking at inflation drivers, the central bank governor reflected that goods price inflation was “clearly slowing due to a better balance of supply and demand following the resolution of the pandemic disruptions” but noted that services price inflation is “still very high and broadly based and the experience overseas points to upside risks”.

Other factors raised by Mr Lowe were unit labour costs (which have been “rising briskly”), subdued productivity growth, a “very tight” labour market (with the unemployment rate at a near 50-year low), and wages growth.

He outlined that wages growth had picked up in response to the tight labour market and high inflation — and while it was still consistent with the inflation target at an aggregate level (provided that productivity growth picks up) — the RBA remained “alert to the risk that expectations of ongoing high inflation contribute to larger increases in both prices and wages, especially given the limited spare capacity in the economy and the historically low rate of unemployment”.

“Accordingly, [the RBA] will continue to pay close attention to both the evolution of labour costs and the price-setting behaviour of firms,” he said.

Economy in for a bumpy ride

Looking to the economic future, the central bank governor warned that “the path to achieving a soft landing remains a narrow one”.

While the RBA does not expect a recession, gross domestic product is forecast to increase. However, GDP will still be recording “below-trend growth” at around 1.25 per cent this year and around 2 per cent over the year to mid-2025.

The unemployment rate is also forecast to increase “gradually” to be around 4.5 per cent in mid-2025.

However, the “significant source of uncertainty” continues to be the outlook for household consumption. 

“The combination of higher interest rates, cost-of-living pressures and the earlier decline in housing prices is leading to a substantial slowing in household spending,” Mr Lowe said.

“While some households have substantial savings buffers, others are experiencing a painful squeeze on their finances. There are also uncertainties regarding the global economy, which is expected to grow at a below-average rate over the next couple of years.”

As such, the RBA governor warned that some “further tightening of monetary policy may be required to ensure that inflation returns to target in a reasonable time frame” but conceded that this will depend upon how the economy and inflation evolve. 

“The board will continue to pay close attention to developments in the global economy, trends in household spending and the outlook for inflation and the labour market,” he said.

“The board remains resolute in its determination to return inflation to target and will do what is necessary to achieve that.”

[Related: RBA makes May cash rate call]