Inflation conflict not won, economist warns
Higher interest rates are likely to prevail until at least the middle of next year, a prominent economist says.
Westpac Business Bank chief economist Besa Deda (pictured above) said that with headline annual inflation at 6%, it was still too early to declare the war on inflation won.
Inflation has peaked and consumers are tightening their belts, however services inflation may prove to be sticky. With inflation still elevated and the Reserve Bank not expecting it to return to target until late 2025, there is “considerable risk and uncertainty” associated with its future path, Deda said.
“This may mean that the cash rate will stay on hold, but high for longer,” Deda said.
The official cash rate, currently at 4.10%, has risen four times this year. The RBA announced no change to the OCR at its previous two meetings in July and August, but has left the door open for further hikes.
In what is described as the most aggressive tightening cycle since the early 1990s, the official cash rate has risen by four percentage points since May 2022.
Some further tightening of monetary policy “may be required” to ensure inflation returns to target in a reasonable timeframe, Reserve Bank governor Philip Lowe said in August, noting that data and evolving risks would determine the path forward.
Interest rate outlook for September
Discussing the bank’s forecast on weekly podcast series MPA Pod, Deda said that interest rate markets currently had a 45% probability attached to one further rate hike in the current cycle, before March 2024.
Westpac’s central case scenario is that the Reserve Bank will leave the official cash rate on hold in September and will not rise further in the current monetary policy cycle, she said.
“The fact that the RBA has stayed on the sidelines for three of its last five board meetings demonstrates that we are at or near a peak,” Deda said.
Inflation heading in right direction, but further rate hike possible
In the year to December 2022, inflation climbed to 7.8%, the annual rate having since dropped back to 6%.
Deda said that Westpac was “very confident” that the pace of inflation had peaked late in 2022. Inflation growth was moderating, and Westpac expected that to continue.
Westpac is projecting that inflation will return to the Reserve Bank target range of 2% to 3% in early 2025, earlier than the Reserve Bank’s expectation of late 2025, she said.
A decline in the annual inflation rate will be driven by goods disinflation, brought about by improvements in supply chains and delivery times, Deda said. In countries such as the US, this process is well-advanced: Australia has been lagging other developed countries in this cycle.
With inflation still elevated and the Reserve Bank not expecting inflation to return to its target band until late in 2025, Deda said that its future path was still dictated by “considerable uncertainty and risk”.
“These uncertainties and risk mean it’s still too early to call the war on inflation won,” she said.
As has been the case overseas, if inflation is sticky or if progress to return inflation to the target band is slow, the RBA may need to “tap on those brakes again,” Deda said. A further interest rate hike could be prompted by an acceleration of wage pressures or if inflation expectations become unanchored.
“For now, the incoming data suggests these risks are contained … the data flow will continue to remain very critical to the rate decisions going forward,” Deda said.
Westpac eyes services inflation, rents
Services inflation and rents are two aspects of inflation that Westpac is keeping a close eye on.
Services inflation is more reflective of what is happening in the labour market and domestic supply and demand factors, making it harder to bring down.
As the annual pace of services inflation (the price for services such as restaurant meals and entertainment) was still accelerating, Deda said that there was a possibility of some “stickiness” in services prices, therefore fuelling inflation.
Rents may continue to be a challenge in the US, and those pressures could continue in Australia, where strong population growth is putting pressure on rents, she said.
Despite government subsidies and policies having some negating impact, energy prices are expected to be another factor contributing to inflation.
On the counter-side, discretionary spending on goods and services is expected to wane as the economy slows and the full impacts of the 12 rate hikes flow through to the economy, Deda said. Medium-term inflation expectations currently remain in check and wages inflation is believed to be approaching a peak in the current quarter.
Cash rate expected to be “higher for longer”
Gross Domestic Product (GDP), considered the main measure of economic activity, is expected to continue to slow.
The RBA is forecasting GDP growth of around 1.75% over next year, and slightly above 2% in 2025.
Deda said that Westpac’s forecast was for actual GDP figures to be closer to 1.5% in 2024.
Putting this into perspective, Deda said that Westpac’s GDP projections could be thought of as a “modest outcome,” sitting well under the potential or trend growth rate in the economy of around 2.6%.
Westpac’s forecast reflects the fact that at its current settings, the official cash rate is restrictive, she said.
“We do think that the cash rate will be higher for longer and we do think that will continue to weigh on economic activity,” Deda said. “Australia will skid close to an outright recession, but at the moment we expect to avoid a recession.”
Timing of first cash rate cut
With headline inflation still elevated at 6%, Deda said that the RBA was unlikely to be in a position to cut interest rates in the near term.
The central bank is trying to engineer a slow return to the inflation target, in part trying to avoid a hard landing and protect some of the gains in the labour market over the past few years.
This may mean that the cash rate will stay on hold, but high for longer, she said.
“We’re not expecting rate cuts to commence until the second half of next year,” Deda said.
“By that time, we expect the RBA will have sufficient evidence that inflation will be back within the target and so they’ll be in a position to reduce the level of the cash rate to provide support to economic activity.”
Interest rate markets are currently placing an almost 50% chance that rate cuts may commence in December next year, she said.
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