Quick Bites | War in Middle East Increases Prospects of Rate Hike
The start of a war between the US and Israel on one side, and Iran on the other, poses the risk of a significant disruption to the supply of oil, particularly through the Strait of Hormuz. The price of Brent oil has risen sharply in the last few days, to around US$78/Bbl, which if sustained for a few months would certainly add to inflationary pressures.
War is a very uncertain business, with a range of outcomes possible. At this stage, markets seem reasonably relaxed that a global oil price shock is not on the cards. Nevertheless, the risks have increased since 28 February that central banks will have to keep a close watch on the oil price. The RBA will be cautious about letting inflation run away and “fall behind the curve”.
Source: AMP
Australian rates
RBA Governor Michelle Bullock delivered a speech on Tuesday 3 March titled ‘Listening to Australians, Interpreting the Data and Setting Monetary Policy’ at the AFR Business Summit. She discussed the recent February monetary policy decision, and the RBA’s thinking around uncertainty.
On the February decision to raise interest rates, Governor Bullock noted that “inflation is too high and that some of the recent increase in inflation is likely to persist”, with staff forecasts showing inflation only coming back into the target band in “mid-2027 – that is over a year away”.
On developments in the Middle East, Governor Bullock noted “a supply shock could, for example, add to inflation pressures” and have “potential implications for inflation expectations”. At the same time, she flagged that “a prolonged impact on energy markets could have adverse effects on global economic activity and result in downward pressure on inflation”.
Source: AMP
The Governor noted “monetary policy must respond to the outlook for inflation and employment, because interest rates take time to affect the economy. This means drawing on all the available evidence to keep testing and refining our central view, and our view of the risks around it.”
On the RBA’s current assessment of economic conditions, Governor Bullock noted “underlying demand in the economy is further from its supply potential than we had assessed six months ago. A range of indicators tell us that labour market conditions are tight. And it is uncertain whether financial conditions are sufficiently restrictive to return inflation to the midpoint of the target in a reasonable timeframe.”
On risks of a supply shock stemming from developments in the Middle East, Governor Bullock noted that ”this one might be a little bit harder [to look through] because … we already have elevated inflation, and there is a risk that expectations might become a little bit unanchored.”
We note that the RBA’s previous research suggests that fuel prices are most salient for inflation expectations.
What are markets expecting?
Governor Bullock’s speech and subsequent Q&A were hawkish. When asked explicitly about the possibility of a March rate hike, the Governor flagged that every RBA meeting is now “live” and stressed that she would dissuade people from thinking the RBA would not hike in March. She said that “inflation is at 3.8% and the unemployment rate is 4.1%, tight”.
The Governor also indicated it was harder to look through a supply shock when inflation was already high, downplayed the appreciation of the AUD as “nothing out of the ordinary”, and observed an unemployment rate well below the RBA’s latest estimate of NAIRU (4.6%).
Indeed, she posed the question regarding the strategy of being patient in returning inflation to target, (this) “does beg the question of how patient can we be?”
The market probably expects the RBA to next hike the cash rate in May (+25bp to 4.1%), but has raised the chances of a rate hike in March to around 30-40% (up from 10% at the start of the week).