Australia stuns markets by raising cash rate 25 basis points

Australia’s central bank on Tuesday stunned markets by raising its cash rate 25 basis points when traders had looked for an extended pause, saying inflation was way too high and warned that even further tightening may be needed to bring it to heel.

The unambiguously hawkish policy stance sent the Australian dollar soaring and bond futures tumbling as markets quickly lifted the peak for interest rates.

Wrapping up its May policy meeting, the Reserve Bank of Australia (RBA) raised rates to 3.85% and said “some further tightening” may be required to ensure that inflation returns to target in a “reasonable timeframe”.

The cash rate now sits at its highest since early 2012, bringing the total RBA hikes in its price battle to a whopping 375 basis points since May last year – the fastest tightening campaign in the nation’s modern history.

Markets, as well as a majority of analysts, had been wagering heavily on a steady outcome given core inflation had eased a little more than expected and the RBA had said at its previous policy meeting that the full pain of the past tightening was yet to be felt in the economy.

The Australian dollar shot up by 1.3% to $0.6715, while three-year futures dived 15 ticks to 96.770.

Futures slid as the market priced in the new 3.85% rate and implied around a 60% chance rates could reach 4.10% by August.

“Inflation in Australia has passed its peak, but at 7 percent is still too high and it will be some time yet before it is back in the target range,” said Governor Philip Lowe, nothing the upside risks in services inflation and rising labour costs.

“Given the importance of returning inflation to target within a reasonable timeframe, the Board judged that a further increase in interest rates was warranted today.”

INFLATION STILL STICKY

The much-watched first quarter consumer prices data last week confirmed that inflation was easing from 33-year highs. However, even after taking into account Tuesday’s hike, it is still projected to return to 3% – the top of the RBA’s target band of 2-3% – in mid-2025, according to the central bank’s latest forecasts.

Inflation is now expected to slow to 4.5% this year, compared with the previous forecast of 4.75%.

“This is an awfully long time for inflation to exceed target, and runs the risk that higher inflation expectations will become embedded,” said Sean Langcake, Head of Macroeconomic Forecasting for BIS Oxford Economics.

“This would ultimately lead to even higher interest rates, which the Bank is looking to avoid as it seeks to keep some momentum in the economy”.

Lowe said the hike on Tuesday would help anchor medium-term inflation expectations.

Both ANZ and Nomura pencilled in another quarter-point rate hike for August.

However, Gareth Aird, head of Australia economics at Commonwealth Bank of Australia who correctly tipped Tuesday’s increase, expects the need for further tightening to dissipate from here, saying past tightenings will tamp down on consumer spending and inflation.

Australia’s battle against inflation mirrors a global campaign by policymakers worried that red-hot prices would do longer lasting economic damage if not quickly contained.

On Wednesday, the Federal Reserve is widely expected to raise interest rates again, by 25 basis points, while the European Central Bank could even surprise with an outsized half-point increase a day later.

RECESSION RISKS

The labour market remained tight, with net employment blowing past expectations in March and the jobless rate hovering at near 50-year lows.

A surge in migration, which could lift population growth to a heady 2.0% this year, is fuelling increases in rents and adding to inflationary pressures.

Also on Tuesday, the RBA lowered the economic growth forecast for this year to 1.25%, from 1.5% previously, while projecting the unemployment rate to increase to around 4.5% in mid-2025.

Governor Lowe will speak tonight at 0920 local time (2320 GMT) to explain the Board’s thinking behind the surprise hike and answer questions from the audience.

Shane Oliver, chief economist at AMP, warned of the economic risks from any further policy tightening.

“We think that the RBA has done more than enough and we have reached the peak in rates. Continuing to raise rates from here adds to the rising risk of plunging the economy into a recession.”