This Post Market Wrap is presented by KOSEC – Kodari Securities

• Headline annual inflation rate 5.1 percent and underlying inflation 3.7 percent
• Current official interest rate setting of 0.1 percent is no longer appropriate 
• RBA dilemma: 0.15 percent increase next week or 0.4 percent next month? 
• Capital markets are braced for interest rates to normalise.  

Not if, but when and how much?  

The Reserve Bank of Australia (RBA) is faced with the prospect of runaway inflation if it doesn’t increase the official interest rate at its board meeting next Tuesday. This is the view of several leading economists in response to yesterday’s inflation data showing that the headline inflation rate is 5.1 percent pa and underlying inflation is now 3.7 percent. This is well outside the RBA’s stated inflation target range of 2-3 percent and the largest annual increase in inflation for more than 20 years. It comes at a time when interest rates are at a 40-year low and unemployment at a near 50-year low. Clearly history is not on the side of the RBA.       

The driving factors pushing consumer prices higher are well documented, and include supply chain cost pressures, higher fuel, grocery, tertiary education, and higher new housing costs. This is before wage cost pressures emerge. Another emerging factor is the recent fresh break-out of COVID in China that is causing lockdowns that may see a worsening of the supply chain constraints for key components of manufactured goods and materials essential to the orderly functioning of the Australian economy. This confluence of events implies that the current RBA official interest rate setting of 0.1 percent is no longer appropriate.

The dilemma for the RBA is that the government is in election mode and any decision not to increase the official rate next Tuesday may be seen as politically inspired. The RBA is an independent Central Bank and must be seen always to act independently. 

0.15 percent increase next week or 0.4 percent next month?

If interest rates are not increased next Tuesday, there is a risk that a rate rise at a later date may have to be higher than if a rate increase is announced next Tuesday. The market consensus is that a rate rise is necessary sooner rather than later, because this is what the data is already telling us: it wasn’t raining when Noah built the Ark!

A minimum 0.15 percent increase to the current 0.1 percent official cash rate, taking the official rate to 0.25 percent, is probable next Tuesday. If not, then the market widely anticipates a higher increase of 0.4 percent in June, taking the official interest rate to 0.5 percent.

If it’s in the news, it’s in the price

Market implications of an official interest rate rise, whether it is announced next week or next month, are likely to be muted, or neutral. Markets react poorly to surprises, and any interest rate rise announcement by the RBA next week, should not come as a surprise. Interestingly, if the RBA doesn’t announce an official rate rise next Tuesday, that may lead to a temporary market sell-off, because no change to official interest rates may come as surprise to some investment market participants. 

You can’t predict the future; but one must prepare for it!

Inflation is here and the present near zero interest rate setting is no longer appropriate. Zero interest rates may explain the current historically high asset prices, but they don’t justify them. Asset price inflation works for many investors (and homeowners), but it doesn’t do much for economic growth. 

This is why interest rates will soon begin to normalise. Investors should prepare for this scenario as it unfolds in the weeks and months ahead.