MNI POLICY: RBA Believes Labour Market Can Absorb Higher Rates

The Reserve Bank of Australia is likely to calculate that a still-tight labour market should allow the economy to absorb some impact from weaker global growth or higher interest rates, MNI understands. 

Officials expect energy price rises to lift short-term two- to three-year inflation expectations, and are closely monitoring whether they drift beyond what fundamentals would imply, as well as whether longer-term five- to 10-year expectations remain anchored — a key gauge of the Bank’s credibility. 

They are still assessing whether the Iran conflict will weigh on demand and feed through to higher unemployment, but they believe both inflation and expectations will be higher than previously predicted in February's forecasts.

While Governor Michele Bullock noted that domestic conditions — not global oil prices — drove last week’s 25-basis-point hike in the cash rate to 4.1%, the RBA would have preferred to enter a potential energy price surge with inflation closer to its 2.5% target. (See MNI RBA WATCH: Timing Drove Split Vote, Not Direction-Bullock) 

Markets have priced around a 64% chance of another increase to 4.35% at the May meeting. 

SHOCK TREATMENT

A critical uncertainty is how households and businesses interpret the shock — whether as temporary or more persistent — and this will determine the extent to which higher prices feed into behaviour, including wage demands and pricing decisions.

While the inflationary impact of higher energy and commodity prices — including fuel, gas and fertilisers — is clear, the effect on growth and the labour market is less certain and will depend on the duration and breadth of the shock. A more prolonged conflict could generate broader second-round effects, particularly given existing capacity constraints in the economy, raising questions over whether price pressures will prove more persistent than in a lower-inflation environment.

At the same time, offsetting factors are in play. Exchange rate movements, potential fiscal support and Australia’s position as a major LNG exporter could cushion the impact, with higher energy prices potentially boosting the terms of trade. Policymakers will need to balance these forces against the Bank’s dual mandate of price stability and full employment, with the net effect of the shock on demand likely to be the key determinant of the policy response.