Australia Raises Key Rate, Signals More Hikes To Come

(Bloomberg) -- Australia's central bank raised interest rates by a quarter-percentage point and signaled further tightening to come as it combats escalating inflation.

The Reserve Bank's board lifted the cash rate to 2.85% from 2.6%, the highest level since April 2013, in a result widely expected by economists. The decision underlined the RBA's pivot away from outsized hikes last month.

“The board has increased interest rates materially since May,” RBA Governor Philip Lowe said in his post-meeting statement. “The board expects to increase interest rates further over the period ahead. It is closely monitoring the global economy, household spending and wage and price-setting behavior.”

The central bank lowered its outlook for economic growth in response to higher rates. The Aussie dollar dropped briefly after the announcement before rebounding, while 3-year bond yields declined about 8 basis points to 3.30%. The benchmark stock index extended gains to as much as 1.3%.

“The tone of the statement was probably not as hawkish as I expected,” said David Plank, head of Australian economics at Australia & New Zealand Banking Group Ltd.  

“The RBA is now prepared to tolerate inflation above target for a longer period. So there's really a key focus on keeping the economy on an even keel. Markets will be pondering the credibility of that.”

The RBA's consecutive quarter-point moves contrast with the Federal Reserve and Bank of England, which are forecast to unleash 75 basis-point hikes this week. 

One reason for the RBA's difference is it meets more frequently -- every month bar January -- allowing it to move in smaller increments. Lowe is also mindful of the impact of higher borrowing costs on a household sector that's struggling under a debt-to-income ratio of 187%.

About 60% of Australian mortgages are also on variable rates, while fixed rates are typically for only two- to three years, unlike the US where 90% of home loans are fixed for 30 years. 

Money market pricing implies a peak in the cash rate of just under 4% by mid-2023, while economists expect a more cautious RBA will halt at around 3.5%. 

So far, Australia's heavily indebted households have proved resilient to higher borrowing costs and a spike in living costs. Data Monday showed retail sales rose more than expected in September. Job ads also remain high, indicating further falls in unemployment that's already hovering near a 50-year low.

The RBA provided some headline numbers from its quarterly update of economic forecasts that will be released in full on Friday. The central bank now expects inflation to peak at around 8% later this year, slightly up from a previous 7.75%. That comes after much-hotter than expected third-quarter CPI last week of 7.3%.

It also lowered its economic growth forecast to around 3% this year and 1.5% in 2023 and 2024. As a result, unemployment is expected to rise gradually to “a little above” 4% in 2024.

Economists predict a sharp slowdown in Australia's A$2.2 trillion ($1.4 trillion) economy in the year ahead. Lowe has acknowledged that policy makers face a narrow path as they navigate a complex set of headwinds. 

A key risk is an accelerating downturn in the housing market. Data Tuesday showed prices declined in every major city last month in response to rising rates and expectations of further policy tightening ahead. 

Still, Treasurer Jim Chalmers played his part for the central bank last week by showing spending restraint in his first budget.

The RBA has highlighted an additional reason for drawing out its tightening cycle with smaller increases, saying last month this would “help to keep public attention focused for a longer period on the board's resolve to return inflation to target.” 

The bank targets inflation of 2-3% over time.

--With assistance from , , and .

(Adds economic forecasts, market reaction, comment from economist.)

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