Last week was an unnerving one for borrowers. A hotter than expected Australian inflation reading sparked fears that interest rates will have to go higher before they go lower.
In case you missed it, the monthly Consumer Price Index (CPI) indicator rose to 3.6% for the 12 months to April 2024. This was up from 3.5% in March and 3.4% in January and February.
Economists had been expecting CPI to fall to 3.4%, so a surprise increase shook financial markets.
The economic team at Westpac Banking Corp (ASX: WBC) has been running the rule over the report. Commenting on April's CPI reading, the bank said:
By subcategory, there were various differences relative to expectations which offset one another – a notable increase in prices for clothing and footwear (+4.0%mth) and a pull-forward of the health insurance premium increase met by another fall in electricity prices, principally due to another round of energy rebates in Tasmania (–1.9%mth).
What does this mean for interest rates?
Westpac's chief economist, Luci Ellis, notes that the Reserve Bank of Australia (RBA) will be watching the data very closely and acknowledges that rate cuts could be pushed back. But Ellis feels the central bank can't wait too long. She said:
With the RBA in data-dependent mode, surprises in the data flow could change the timing of rate cuts, but not the underlying decision process. The RBA Board recognises that monetary policy is currently contractionary. At some point, it must reduce that restrictive stance and return to something closer to a level it considers to be 'neutral'. Otherwise, inflation would eventually decline below the target range. Because monetary policy works with a lag, rate cuts need to start before inflation has returned to target.
The good news for homeowners is that Ellis continues to believe that interest rates will start heading lower from around November. The chief economist adds:
The question the RBA Board will be asking itself is what it needs to see to be confident that inflation will return to target soon. The likely trajectory of disinflation from here precludes a rate cut much before November. Trimmed mean inflation was still a full percentage point above the top of the target range over the year to the March quarter. Services inflation – a key focus for the RBA Board at present – remains elevated. It will take time for enough evidence to accumulate to convince the Board that the disinflation is on track.
But if things turn out as we expect, a forward-looking central bank would want to start reducing the restrictiveness of policy by about November.
This will see interest rates end the year at 4.1%. After which, Westpac is forecasting rates to fall to 3.85% by March 2025, 3.6% by June 2025, and then 3.1% by December 2025.
