The RBA hikes to 4.35%

The RBA’s decision to hike rates to 4.35% was no surprise with it being about 75% factored in by the money market and 21 of the 22 economists surveyed by Bloomberg expecting a hike. The decision means that the RBA has now reversed all of the three rate cuts we saw last year, which followed 13 rate hikes in 2022 and 2023. Once passed on to mortgage holders it will leave mortgage rates around levels prevailing in late 2011. For a mortgage holder with an average $660 mortgage this will mean an extra $110 a month in mortgage payments or $1300 a year.

Growth down, inflation up – a whiff of stagflation

The RBA revised down its growth forecasts compared to February reflecting the impact of the War and a higher money market profile for the expected cash rate. While it revised up its unemployment forecast for 2028 it was only marginally to 4.7%. It also revised up its forecasts for trimmed mean inflation for the next year reflecting second round impacts from the War, but then sees it falling in 2027-28 back to target as higher rates and lower growth lead to lower demand and hence lower pricing.

This is a dismal outlook with growth of 1.3-1.4% for two years, a poor inflation/growth trade-off and higher unemployment. It’s a whiff of stagflation. The risk is that unemployment ends up much higher than the RBA’s 4.7% forecast.

Key reasons for the rate hike

In hiking rates again, the RBA noted an expected further boost to inflation from the War including via second round effects, at a time when inflation was already too high and increasing concern that inflation expectations will rise as a result. It is clearly more concerned at this point about inflation (where it is underperforming relative to its objective) than full employment (where it is arguably meeting its objective at least for now).

Governor Bullock’s press conference comments basically reinforced these concerns and left the door open for further interest rate hikes if needed.

The RBA also indicated it will remain “attentive to the data”. If unemployment remains lowish but underlying inflation high, then more rate hikes are likely. But if unemployment starts to rise sharply relative to inflation, then it will put a brake on RBA hikes.

With the RBA hiking and the money market still expecting another 1.5 rate hikes by year end (on top of this one), interest rates in Australia are moving higher relative to other major countries. This reflects other major countries mostly having inflation much closer to target before the War started, whereas Australia already had an inflation.

The oil supply shock makes the RBA’s job difficult

It was hoped at the time of the last RBA meeting in March that we would have more clarity around the Iran War. And a collapse in Australian petrol prices to near pre-War levels helped along by the fuel tax cuts and an easing in the immediate fuel supply fears of a month ago may be providing a sense of complacency. Unfortunately, the outlook for the War is as clear as mud. Trump wants to TACO but Iran remains intent on inflicting economic pain until the US backs down more. The Strait remains closed and Iran is responding militarily to any move by the US to prize it open without at the same time the US lifting its own blockade on Iranian shipping. So, it’s a standoff.

And the longer the Strait remains closed the greater the odds of a severe bout of stagflation – with inflation well above 5% and recession – as the full implications of the implied 10-15% hit to global oil and gas supply will become apparent as oil reserves run down.

This would mean higher oil prices (possibly up to around $US150 a barrel), and for Australia a sharp rebound in petrol prices from the recent lull and fuel rationing which will lead to a bigger boost to inflation initially and hit to economic activity. It’s not our base case – as the pressure on Trump to strike a deal with Iran (no matter how vacuous) is very high given the approaching midterm elections. But the risk rises for each day the Strait remains effectively blocked. This leaves the RBA in a difficult balancing act – should it focus on inflation or worry about the hit to growth and the risk of a much bigger rise in unemployment?

The 1970s suggests keeping inflation down is key

The experience of the 1970s holds key lessons for today. It saw inflation progressively surge into double digits in response to labour and oil shocks, rapidly rising government spending and overly easy monetary policy. Importantly, inflation had already started to rise before the first oil shock in 1973. It contributed to even higher inflation and weak growth and rising unemployment giving rise to the term stagflation. Then like now central banks grappled with whether to target inflation or weak economic activity but initially ran too easy monetary policy which allowed inflation to get out of control with surging inflation expectations which then meant that ultimately to get it under control in the 1980s (and 1990s in Australia) very tight monetary policy and deep recession were required. The key lessons were that: entrenched inflation is bad for the economy as most lose from cost of living pressures; once the inflation genie gets of the bottle it gets harder and harder to get it back in as inflation expectations rise; and that whether its initially due to a hit to supply or strong demand the central bank has to respond by tightening monetary policy and focussing initially on keeping inflation down to avoid a higher cost later.

History doesn’t repeat but it does rhyme and there are several parallels today with the 1970s – bigger government, deglobalisation, decarbonisation and aging populations have already made the economy more inflation prone and with the oil shock we are now seeing the third supply shock this decade (following the pandemic and the Ukraine War). And the Iran War threatens a further rise in underlying inflation with many reports and anecdotes of price rises for everything from airfares to toilets. Underlying inflation may also be boosted if fuel shortages lead to supply side problems. And with Australian inflation already above target and now likely to be more so the greater the risk that this will flow through to higher inflation expectations leading to higher wage demands and business being more inclined to put through bigger price rises. The longer inflation stays above target, and it now looks like doing so for five of the last six years including the present year, the more people will expect it to stay above target and the harder it will be for the RBA to get it back down. Businesses are already reporting a big rise in price pressures. This effectively blew my pre-War optimism on inflation out of the water!

So the RBA is right to be concerned and wants to show that it remains determined to get inflation back to target and to not let it spiral higher as occurred in the 1970s. This is not about thinking that higher rates can get fuel costs back down but rather is about bring demand in the economy back into line with supply and showing that its serious about: preventing a further flow on to underlying inflation; wanting to see inflation go back to target in a reasonable time frame; and trying to keep inflation expectations down.

The risk of course is that higher mortgage rates combined with War drag Australia into recession. Household spending power will be hit by a combination of the three rate hikes (which in total will cost around $300 a month in higher interest payments for those with a mortgage) and a likely rebound in petrol prices with the Strait remaining closed. Households with a mortgage are far more sensitive to changes in their disposable income than older Australians who may benefit from higher rates on their bank deposits. It’s also worth noting that the value of household debt in Australia is almost double the value of household bank deposits so higher rates cost the household sector far more than it benefits it. And fuel rationing possibly in June if the Strait remains closed will have a broader impact on the economy in curtailing some activities. Australia is particularly vulnerable on this front as we import 80-90% of our oil products.

All up and depending on how long the oil disruption lasts, in a worst case scenario the hit to economic activity could knock 1 to 2 percentage points off GDP growth and knock the economy into a recession.

On balance we think that the potential significant hit to economic growth cannot be ignored by the RBA. Although the June RBA meeting will be “live” for another hike our base case for now is that it will leave rates on hold waiting to get a better handle on the hit to the economy from the rate hikes so far and the impact from the oil supply shock. We are pencilling in one last rate hike for August though, but see the RBA cutting rates next year as weaker growth starts to bear down on inflation.

How can the Government take pressure off the RBA?

Further cost of living relief in the Budget should hopefully be limited given the risk of just adding to demand and hence inflation. More fundamentally the Government should focus on reducing capacity pressures in the economy and boosting capacity. The three key things it needs to do this are: to cut government spending back to the normal levels that prevailed pre covid; deregulate the economy to make it easier to start new businesses, employ people and supply more homes; and reform the tax system to in particular lower income tax and encourage business to invest more. Fiddling with negative gearing and capital gains tax – while they have some merits – are more about optics than fundamentals on this front.

Dr Shane Oliver – Head of Investment Strategy and Chief Economist, AMP

Introduction

The past week provided welcome relief in the Iran War, with Trump delaying for two weeks his threat of the “complete demolition” of Iran’s power plants and bridges. So far its all very shaky, but whether the “ceasefire” holds or not and the War de-escalates or escalates from here, there will be significant long-term implications, beyond the near term stagflationary impact that already looks likely this year. The long-term implications will mostly serve to reinforce existing trends towards deglobalisation, increased geopolitical risk, even bigger government and higher inflation pressures.

TACO time – the current state of the War

Trump’s decision to backdown and announce a ceasefire was consistent with his pattern of making exorbitant demands then backing down as pressure grows intense. This time around his poll support was collapsing, markets were threatening to riot, and he was in a no-win situation with Iran. It clearly has plenty more missiles and drones and, if he escalates, it would use them, worsening the global impact. While Trump has military superiority, Iran has weaponised the Strait of Hormuz to control global oil supplies. So, it is a sort of MAD – mutually assured destruction – stand off from which Trump ideally has to back down. Renewed US/Iran talks have failed to reach agreement, with Trump declaring “whether we make a deal or not makes no difference to me. And the reason is because we’ve won”. But then he announced a new contradiction – the US will itself block shipping in the Strait, but at the same time its Navy will begin demining it! Of course he may soon say something completely different. Overall, we lean to the view Trump will find a way to keep the ceasefire going given the political pressure he is under, but uncertainty is high.

For now, the Strait remains the key, because the last ships that made it through at the end of February are now reaching their destinations meaning refineries in Asia will soon start to run low on oil to refine. So the resultant 10-15% hit to global oil supply (after allowing for diversions, eg, via the Saudi East-West tunnel) will start to bite this month. All of which risks a renewed surge in oil prices – to maybe around $US150/barrel in order to curtail consumption – and plunging share markets.

The nascent pick up in the flow of shipping could resume. But if this comes with Iran and/or the US controlling the flow (with fees and vetos) it will be an unstable solution – as the rest of the world won’t accept such an outcome indefinitely, given the precedent it will set. This would point to a resumption of the conflict. Maybe after the midterms are over, when Trump is less politically constrained, or if his and Republican polling gets so bad that he has nothing to lose by escalating again.

Even if there is a quick end to the War it will take months for global oil flows to return to normal given the time it will take to resume energy extraction in the Gulf (weeks & months for oil, years for some gas plants), to then load this on to ships and for those ships to arrive at refineries in Asia. And then for the refined products to reach Australia.

So, a near term stagflationary impact of higher inflation and weaker growth is now baked in. In Australia, we see inflation peaking around 5-5.5% in the current quarter and GDP growth slowing to around 1.5% this year. With oil supplies coming to crunch time this month the risk of recession in Australia is now high. For central banks wary of letting inflation expectations rise, the focus is likely to be initially on the boost to inflation rather than the hit to growth. This is the case in Australia where inflation was already well above target and signs of rising wage demands will worry the RBA. So, we are allowing for more RBA rate hikes this year.

The longer-term consequences

Beyond the uncertain short term stagflationary impact the War will leave a longer-term impact on economies and markets in nine key ways.

1. Higher prices, inflation and inflation expectations – having another hit to supply and boost to inflation so soon after the last one in 2022 and on top of the tariff impact in the US will lead to another leg up in prices. This runs the risk of a further boost to inflation expectations and loss of faith in central banks’ ability to get inflation back to target.
2. Increased geopolitical risk – this has been on the rise ever since the 2010s due to a loss of faith in liberal democracy reflecting rising inequality, increasing nationalism and populism and a shift away from a unipolar world (dominated by the US) to a multipolar world. The US has gone from chief defender of liberal democracies to a force propelling this shift under Trump with his focus on doing what he wants for America, trashing the global rules-based system, attacking allies (and treating them as scapegoats for his mistakes on Iran) and acting like a “madman” which is leading to a loss of credibility for the US. This has been particularly evident this year with the US intervention in Venezuela, attempt to take Greenland (which he is still on about) and now Iran. It’s hard to see this not being interpreted by other powerful countries as a green light to do whatever they want in their region and beyond. I would rather Ray Dalio’s assessment that the world is heading down a path that risks broader conflict be wrong, but it can’t be ignored. What’s going on now with Iran is the sort of thing that world wars start over.
3. A new generation of terrorists – the Israel/Gaza war and now the Iran War risk driving a renewed rise in terrorism. Economies and markets can look through terror attacks that are limited in impact – as we saw in the 2000s – but this would change if the damage was more general.
4. Increased defence spending – this is an inevitable result of increased geopolitical risk. It will also be fuelled by Trump’s renewed contradictory attacks on NATO countries and other allies including Japan and Australia – for not joining in on the attack on Iran. Particularly so if the US decides to leave NATO as it’s been alluding to.
5. Increased spending on oil and gas infrastructure – while Trump appears to have been surprised and frustrated by Iran’s move to control the Strait of Hormuz (through which 20% of global oil and gas flows) as evident in his “Open the F…… Strait, you crazy bastards” comment, it’s entirely logical and had long been predicted if Iran found itself threatened. It was why Saudi Arabia built its East-West oil pipeline in the 1980s. Now that it’s happened, it provides yet another reminder of the global energy dependency on a highly volatile part of the world. This was on display in the 1970s but was forgotten about from the 1980s as oil shocks were brief. It’s likely to mean increased efforts by Gulf countries to bypass the Strait and medium term moves by other countries to boost their own oil and gas reserves.
6. Increased focus on renewables and nuclear energy – over the longer term the crisis will further boost demand for renewables and nuclear on the simple logic that the sun, the wind and nuclear energy do not depend on volatile politics in the Middle East. This is already evident with motorists reportedly scrambling to buy electric cars (which are now around 15% of new car sales in Australia).
7. Yet more pressure to onshore supply chains – this is on top of the pressure flowing from the pandemic for medical equipment but will now focus on oil refining, aluminium, fertiliser etc which are all being impacted by the War. Future Made in Australia will likely see another leg up. Which all means more protectionism and deglobalisation.
8. Yet another reminder that it’s now a more crisis-prone world – the Iran War is now the fifth major global shock in the last 20 years with the others being the GFC, the Eurozone debt crises, the pandemic & the 2022 inflation shock. While there were crises before that – the tech wreck, the Asian crisis, the early 1990s recession – they now seem more frequent & less related to traditional economic cycles.
9. Bigger government and more public debt – more defence spending and government involvement in economies, eg in onshoring, mean more public spending, bigger budget deficits and ever higher public debt – at a time when its already high. The latter is particularly evident in the US with Trump pushing for a $500bn (or 42%) defence budget boost when the US budget deficit is running around 6.5% of GDP despite low unemployment suggesting it should be in surplus.It could also be evident in the upcoming Federal Budget in Australia, which is likely to see more “cost of living” help for households and business at the expense of commitments just a few months ago for the Budget to focus on savings in the level of spending and on productivity enhancing reforms. Another year of stronger spending growth will add to concerns that it will never be brought back to more sustainable levels, as in 2027 the focus will return to the next election.Ever higher public debt and rising bond yields also run the risk of a public debt crisis at some point.

Implications for investors

There are three key implications for investors.

First, a somewhat less favourable economic outlook – if governments play an increasing role in the economies (via more defence spending, onshoring and protectionism), it’s likely to mean lower productivity resulting in slower economic growth and higher inflation. In short, lower living standards. In the US at present, it’s being fortuitously masked by the AI boom – but this could be a double-edged sword in the near term.

Second, the boost to geopolitical risk and reinforcement of populism and nationalism (notwithstanding the counter trend election outcome in Hungary) means increased uncertainty, including for businesses.

Finally, all of which runs the risk of more constrained and volatile investment returns. Which should mean that shares should be offering a higher risk premium over bonds. But at present the risk premium offered by US and Australian shares – as measured by the forward earnings yield less 10-year bond yields – remains very low.

Dr Shane Oliver – Head of Investment Strategy and Chief Economist, AMP