(Bloomberg) — The debate over whether Australia’s central bank needs to tighten monetary policy late in the economic cycle is likely to be resolved with quarterly inflation data due this week, sending the Australian currency soaring in the aftermath.
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Ahead of Wednesday’s release, economists expected consumer prices to rise 3.8% in the second quarter from a year earlier, up from a 3.6% increase in the previous quarter. Trimmed average inflation, a key measure to balance price movements, is seen to remain at 4%. That’s above the central bank’s latest forecast of 3.8% and suggests progress in containing prices is limited.
“If inflation is at the 4 percentage point mark and they don’t raise rates, then the credibility of fighting inflation starts to erode significantly,” said Stephen Miller, investment strategist at GSFM. “That could mean that longer-term Australian government bond yields will stagnate, certainly below U.S. Treasuries.”
The RBA has raised interest rates less sharply than many other central banks as it seeks to maintain job growth but worries about the ability of highly indebted households to cope. Unabated inflation means the RBA is unlikely to meet its target of getting inflation back to 2-3% by the end of next year, likely necessitating further rate hikes and risk plunging the weak economy into recession.
The price report came on the heels of better-than-expected job gains and stronger retail sales, while a gauge of business surveys remains solid. A partial measure of prices rose more than expected for a third consecutive month in May, raising questions about whether policy is “containative enough.”
The RBA has pledged to remain “vigilant” against the risks of rising inflation, and its policy committee considered raising rates in June before deciding to keep them at 4.35%. Money markets still see a one in four chance that the RBA will tighten monetary policy when it meets on August 5-6, though that probability has decreased since earlier this month.
“Australia’s inflation rate is still high compared to the rest of the world,” said Diana Musina, deputy chief economist at AMP. She said a quarterly result above 1 percent would put inflation further away from its target, “which would likely lead the Reserve Bank of Australia to raise interest rates.”
Economists expect inflation to rise 1% from the previous three months.
Financial markets and policymakers are not the only ones nervously awaiting the announcement: If inflation subsides and the interest-rate hike debate ends, a center-left government could still call a general election early this year, but with prices rising apace and the threat of further tightening looming, that seems unlikely.
“Raising interest rates poses a challenge for the current government with inflation and the cost of living still being issues,” Martin Whetton, head of markets strategy at Westpac Banking Corporation in Sydney, said.
Inflation last quarter was likely driven by home rents, housing costs, insurance and financial services. Additionally, government spending remains strong, especially at the state level, boosting demand and prices.
S&P Global Ratings said on Monday that Australian state budget deficits are among the highest in the developed world. It expects state debt to exceed A$600 billion (US$394 billion) by the second half of 2024, more than double its pre-pandemic level.
Australia’s cautious policy puts it in the late stages of the global economic cycle as the Reserve Bank of Australia discusses raising interest rates while some other countries have already eased. The exception is the Bank of Japan, which Bloomberg Economics expects to raise rates on Wednesday.
Elsewhere, the Bank of Canada has made successive rate cuts, the European Central Bank has also cut interest rates, and China, Australia’s largest trading partner, has cut its borrowing costs.
The Federal Reserve is likely to set the stage for a policy shift in September when it meets this week, and a particularly dovish Fed may warn the Reserve Bank of Australia to hold off on raising interest rates.
“With the looming risk of monetary easing from China and the Fed and other developed central banks, the RBA is keen to fine-tune monetary policy when the economy is trending downwards,” said Prashant Neunach, Singapore-based senior rates strategist at TD Securities.
Pointing to the recent sell-off in the Australian dollar, Neunaha said “it is unlikely that the Consumer Price Index (CPI) will rescue the decline.”
The Australian dollar has fallen 1.6% against the greenback this month, the smallest decline among major developed currencies, as falling commodity prices and concerns about the Chinese economy have hit risk sentiment. The Australian dollar had previously been the top performer in forecasts of RBA interest rate hikes, but the decline has now reversed.
–With assistance from Shinjini Datta and Ben Westcott.
(Adds commentary from S&P analysts on state deficit and market value.)
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