MNI: RBA Strategy To Hinge On Iran Conflict After Likely Hike

The Reserve Bank of Australia is likely to hike the 4.1% cash rate once more, but its strategy beyond that will hinge on how long it expects the oil supply shock to persist, former officials told MNI, adding that the Federal Government’s recent fuel excise cut was probably premature and inflationary. 

John Hawkins, a professor at the University of Canberra and former RBA economist, noted that the Bank’s own January forecasts do not return inflation to the midpoint of the target range even after the most recent increase. (See MNI RBA WATCH: Timing Drove Split Vote, Not Direction-Bullock)

“Whether they go further will depend on developments in the Middle East and on longer-term inflation expectations,” Hawkins said. “If people start to doubt the Bank’s commitment to bringing inflation back down, and medium-term expectations rise, then they are likely to hike more.” (See MNI POLICY: RBA Believes Labour Market Can Absorb Higher Rates)

Markets have priced in a 59% chance of a 25-basis-point hike to the 4.1% cash rate at the next May 5 meeting and a 4.6% rate by December. 

Whether Australia enters a recession that would warrant rate cuts will depend on the duration of the Iran conflict, Hawkins added. 

“A lot hinges on what happens in Washington and how Iran responds. It’s not positive — more countries appear to be getting drawn in,” he said. “Iran still has the capacity to disrupt energy infrastructure across the region, and how far that goes will depend on whether the U.S. pulls back or escalates further.”

The government’s fuel excise cut could add to inflation, though it should provide short-term relief to households.“I think the balance has shifted,” Hawkins said, pointing to the federal budget due in May. With government already focused on cost-of-living pressures, it may find it harder to prioritise longer-term productivity-enhancing reforms if the near-term economic outlook deteriorates, he concluded.

Hawkins’ comments were made prior to a two-week ceasefire tentatively agreed between Iran and the U.S. on Wednesday morning (AEST).

SEVENTIES PARALLELS

Adrian Pagan, professor of economics at the University of Sydney and an RBA board member between 1995 and 2000, said economies may simply have to adjust to higher energy costs, and pointed to the 1970s oil price shock.

“The oil-to-other intermediate goods ratio in the U.S. economy fell sharply after those shocks. Producers shifted to gas or nuclear, and consumers stopped buying the gas-guzzling giants of 1973. But it had the right effect.”

He said the 1970s shock was best understood as a permanent price increase. "Cartels often broke down due to incentives to defect, but OPEC appeared more ideological. So if the price rise was to be permanent, one needed to allow that to go though and work out how to handle the downturn."

Poor policy responses at the time contributed to stagflation, he said.

“That period wasn’t handled well, as oil price increases were offset with wage rises. It takes a long time to unwind those second-round effects.”

The Australian government’s move to cut fuel excise is also a mistake, he said. “I don't think I would have cut them at this point. That is politics overriding economic assessment. If you think the increase in fuel prices is permanent, you wouldn’t do an excise cut,” he continued. 

The key question today is the persistence of the shock, Pagan said. “Trump sounds more like a Dalek every day, so it’s hard to know what to expect on prices.”