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Bank of England's rate hike: implications for RBA

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2023-06-23

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The surprise decision by the Bank of England overnight on Thursday to raise its key rate by a substantial half a per cent to a 15-year high of 5 per cent carries a significant message for Australia as the next meeting of the Reserve Bank of Australia (RBA) approaches on July 4.

The unexpected rate increase appears to be a somewhat panicked reaction to the news that consumer price inflation in the UK remained unchanged in May at 8.7 per cent compared to April. Andrew Bailey, the Governor of the Bank of England, stated that his intention was not to induce a recession, but the outcome of avoiding one is becoming increasingly challenging.

In contrast, the situation in the United States seems more positive, with the US Federal Reserve believing that it has managed to avoid a crisis and is anticipating a soft landing later in the year and early in 2024. This projection includes a GDP growth forecast of 1 per cent, surpassing the gloomy 0.4 per cent prediction made in March, and a lower unemployment rate of 4.1 per cent next year instead of the previously forecasted 4.6 per cent.

During his testimony before the US Congress, Federal Reserve Chair Jay Powell made it clear that the central bank's decisions on interest rates will be data-driven. Powell stated that the data would guide their actions, emphasizing that the importance of quick decision-making has diminished compared to the previous year.

It is evident that the US economy is in a better position compared to the UK or Australia.

While it is too early to determine what lies ahead for Australia, the UK is heading towards a potential crisis, given the persistently high food prices that have remained elevated for the past three to four months. UK inflation reached its peak at 11.1 per cent in October last year. In comparison, the US experienced a peak inflation rate of 9.1 per cent in June last year, while Australia's peak inflation rate was 8.4 per cent in December of the same year.

Following two consecutive 0.25 per cent increases, the RBA's cash rate has reached 4.1 per cent, and most forecasters predict it will rise to 4.6 per cent. This suggests the possibility of further rate hikes of 0.25 per cent in July and August, or a return to a 0.50 per cent increase, similar to what the Bank of England and RBA did several times last year.

The Bank of England's decision has paved the way for the RBA to potentially implement a 0.50 per cent rate increase next month, following the example of Norway's central bank, which raised its rate to a 15-year high of 3.75 per cent on Thursday. The central bank also indicated that it would consider another increase in August.

The likelihood of a 0.50 per cent rate rise in Australia has increased due to the upcoming release of the monthly inflation indicator next Wednesday. If the data shows persistently high inflation, it will almost certainly lead to a larger rate increase than initially forecasted.

The elevated rate will be influenced by the comparison between May of this year and May of the previous year when the 50 per cent reduction in fuel excise was in effect. This reduction expired in September, and in April of this year, the higher rate was compared to the same month a year ago, resulting in an annual inflation rate of 6.8 per cent. Excluding the influence of the fuel excise cut, as well as fruit and vegetables, the inflation rate was 6.3 per cent.

The RBA and the markets focused on the 6.8 per cent figure, and they are likely to do the same next week when the May indicator is released. Even if there is a slight decrease in the rate, the chances of a 0.50 per cent rate rise have increased due to concerns about persistent inflation and higher wage settlements expressed in the minutes of the RBA's June meeting and subsequent comments by Governor Lowe.

However, a significant rate increase could have consequences for Governor Lowe's position, considering the impact of the rate hikes in May and June and the justifications provided for both increases. Treasurer Chalmer announced on Thursday that the new governor would be appointed in July and would assume office from October 1st.

So, what does all this mean for the new governor and the review of the central bank?

First, regarding the review of the central bank, it is important to note that the monetary policy setting structures differ between countries.

The US Federal Reserve, for example, has no external members on its Open Market Committee, which comprises 19 members, including the 7 board members of the Fed and the heads of the 12 Fed districts across the US. While not all members are economists, they are all insiders. In contrast, the UK and some other central banks have a main board and a separate monetary policy committee, which has had varying levels of success compared to the Fed and the RBA over the years.

Currently, the Bank of England is facing difficulties in controlling inflation, which have persisted for almost a year. The UK's economic situation is unique, with the ongoing impact of Brexit affecting economic activity and the financial strength of the country, making inflation control challenging. Additionally, political disruptions caused by the Conservative Party government's late-year leadership change last year further hindered the Bank's efforts to manage inflation.

In summary, the Bank of England's surprise rate increase sends a message to Australia as the RBA's next meeting approaches. While the US economy appears to be in a better position than the UK or Australia, the RBA may consider following the Bank of England's example and implement a 0.50 per cent rate increase in the near future. The decision of the new governor, who will be appointed in July, will also play a significant role in shaping the central bank's policies and addressing the challenges of controlling inflation and maintaining economic stability.

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