Shadow Board: Little Doubt that Cash Rate Should Be Lifted Again

Despite weak wages growth, the labour market remains buoyant and inflation, at 6.1% (Q2 of 2022 for headline CPI and 4.9% for core inflation), well above the RBA’s target band of 2-3%. Other indicators also suggest that inflation will remain elevated for a while: a historically high capacity utilisation rate, global supply chain constraints, and high energy and food prices. Consequently, the RBA Shadow Board strongly advocates in favour of further interest rate increases. It is 89% confident that the overnight rate should be raised to above the current setting of 1.85%, with a mode recommendation of a 50 bps increase, whilst only attaching an 11% probability that keeping the overnight rate on hold this round is the appropriate policy.

Australia’s seasonally adjusted unemployment rate dropped further, to a new record low of 3.4% in July 2022. Youth unemployment, too, dropped, from 7.9% to 7.0%. Total employment fell by 40,900; however, the labour participation rate, after reaching a historic high of 66.8% in June, fell to 66.4%, explaining why this drop did not raise the unemployment statistic. Unsurprisingly, total monthly hours worked in all jobs also fell, by 16 million, or 0.8%. Other labour market indicators such as underemployment, job vacancies and job advertisements remain strong, painting a favourable picture overall of the Australian labour market. The seasonally adjusted wage price index grew by 2.6% year-on-year in Q2, up from 2.4% in the previous quarter, but slightly below market forecasts. This number implies a further erosion of real wages and raises the puzzling question why nominal wages are not able to keep pace with inflation. There is growing concern among workers, unions, policy makers and even some businesses that real wages need to rise, along with productivity.

After a small rally early in the month, the Aussie dollar retreated, finishing the month of August a little above 68 US¢. Should the Federal Reserve in the U.S. continue to tighten monetary policy aggressively and the RBA does not follow the U.S. lead, the widening interest rate gap will put downward pressure on the Aussie dollar and make imports more expensive. Yields on Australian 10-year government bonds have resumed their climb, to around 3.7% at the end of August. Interest rate spreads increased slightly and yield curves retain their normal convexity. The spread between 10-year versus 2-year bonds now equals 49 bps. Australian stock prices again emulated the behaviour of the Aussie dollar – after a temporary high in the middle of August, stock prices dropped: the S&P/ASX 200 stock index finished the month just above 6,850, a 300 point decline in the space of two weeks.

Consumer confidence continued its decline: the Melbourne Institute and Westpac Bank Consumer Sentiment Index dropped for the ninth month in a row, from 83.8 to 81.2. July retail sales, on the other hand, were healthy. Business confidence is mixed; NAB’s index of business confidence jumped from 1 in June to 7 in July, as did the services PMI (from 48.8 to 51.7, July), while the manufacturing PMI and the S&P Global Australia Composite PMI dropped again (from 52.5 to 49.3 and from 51.1 to 49.8, in August, respectively). Remarkably, the capacity utilisation rate increased by nearly two percentage points, to a new historic all-time high of 86.68%. In the same month, the Westpac-Melbourne Institute Leading Economic Index declined by 0.2% year-on-year, for the second month in a row.

Australian house prices recently experienced their biggest monthly decline in several decades, according to CoreLogic, as higher interest rates, and the prospect of further increases, are weighing on demand, particularly for first home buyers. A further decline in dwelling values is widely expected, well into 2023, before the market is likely to stabilise. Lower house prices, coupled with higher interest costs, should put the brakes on aggregate demand, thus easing inflationary pressures, but it may yet be months before this wealth effect works its way through the economy.

The impact of fiscal policy will become much clearer in a couple of months, after the Government announces its first budget. Some significant structural policies may also come out of the recent Jobs and Skills summit.

Uncertainty around the global economic outlook remains high. Strong U.S. consumption, fuelled by government stimulus funds and $2.5 trillion of excess household savings, according to the Brookings Institution, was matched by a healthy expansion in U.S. manufacturing. However, factory activity in other parts of the world, particularly in China and Europe, fell. There are growing signs that several Eurozone countries risk sliding into recession, with the possibility of severe disruptions on the back of gas shortages and high energy prices. Global supply chains continue to be obstructed owing to China’s Covid-19 response and geopolitical tensions. These are unlikely to ease any time soon.

Four months ago, the Reserve Bank of Australia embarked on a tightening cycle after the official cash rate target stood at the historically low level of 0.1% for one-and-a-half years. For the current (September) round, the Shadow Board is advocating that the overnight interest rate be raised further, above the current level of 1.85%, attaching an 89% probability that this is the appropriate policy stance. It attaches an 11% probability that keeping the overnight rate on hold is the appropriate policy and a 0% probability that a decrease is appropriate.

The probabilities at longer horizons are as follows: 6 months out, the confidence that the cash rate should remain at the current setting of 1.85% equals 1%; the probability attached to the appropriateness of an interest rate decrease equals 5%, while the probability attached to a required increase equals 94%. One year out, the recommendations are similar. The Shadow Board members’ confidence that the appropriate cash rate is 1.85% equals 0%. The confidence in a required cash rate decrease, to below 1.85%, is 3% and in a required cash rate increase, to above 1.85%, equals 98%. Three years out, the Shadow Board attaches a 0% probability that the overnight rate should equal 1.85%, a 7% probability that a lower overnight rate is optimal and a 93% probability that a rate higher than 1.85% is optimal.

The range of the probability distributions for the current and 6-month recommendations shifted up, along with the 50 bps increase of the overnight rate: for the current setting, it extends from 1.85% to 3%, and for the 6-month horizon it extends from 1.5% to 4.25% (compared to a range of 1.0% to 3.75% in the previous round). The range for the 12-month horizon widened substantially in both directions of the distribution, reflecting heightened uncertainty about future upside and downside risks. The range extends from 0.5% to 5.0% (compared to a range of 1.0% to 4.75% in the previous round). For the 3-year horizon the range widened by 50 bps to the downside, extending from 0.5% to 6.0%

Outcome date: 
Tuesday 06 September 2022
Current rate: 
12 months: 
6 months: 
3 Years: 

Updated:  27 November 2022/Responsible Officer:  Crawford Engagement/Page Contact:  CAMA admin