The Westpac Melbourne Institute’s Consumer Sentiment Index fell just 0.9% from 84.4 to 83.7 in the October survey.

The index remains in deeply pessimistic territory but could have been much weaker.

As stated when we published the survey results, we examined both samples over the four-day period.

The first sample (covering day 1 survey responses) predated the RBA’s decision to raise the cash rate by 25 basis points. The second sample covered responses following the rate decision.

The first sample (sample of 476) showed a sentiment index of 77.4 – down 8.3% from September’s print of 84.4.

But the second sample index (a sample of 724) printed an index of 88.7 (up 5.1% from the September print). The difference between the two surveys represents a reversal of 14.7%.

The upturn in housing market confidence has been even more dramatic. The first sample measuring the Westpac Melbourne Institute’s House Price Expectations Index showed a 16% decline in the index, while the second sample showed an increase of around 8% from September print.

This dramatic move in the Index is most likely attributable to the Reserve Bank’s decision to raise the policy rate by “only” 25 basis points despite market prices giving around a 90% chance of a 50 basis point hike. basis points.

In the 30 years since the RBA’s politics and markets, I can’t recall the RBA moving against market expectations when the odds were so high.

The key indicator for the sentiment survey was media reports that took the lead in market prices and signaled a very confident expectation to the public that another 50 basis point move was in store.

We can commend the Board for a courageous decision while pointing out some likely unintended consequences.

Westpac was expecting a 25 basis point move until we were forced to raise our forecast for the final fed funds rate by 125 basis points to account for much more aggressive FOMC guidance and surprises. bullish US inflation.

Raising our “world rates” forecast by 125 basis points, we raised our terminal rate for the RBA cash rate by 25 basis points to 3.6%, with the upward adjustment taking place in October – a move of 50 basis points instead of our previous preference for 25 basis points.

Since the Australian economy is much more sensitive to the cash rate than the US economy to the federal funds rate, it is not appropriate to follow the full FOMC price hike.

The main adjustment came in our AUD/USD forecast with a US7¢ drop in the exchange rate likely by the end of 2022 to US$0.65.

With the surprise 25 basis point move, the market lowered its terminal cash rate by about 50 basis points. Central banks like to see markets do their job for them, so lowering fixed rates only adds to the task of easing demand pressures.

From our perspective, this price reaction was a surprising reaction to the RBA’s decision and an unintended consequence of the decision.

We observe from the confidence rally in the Sentiment survey that the RBA’s decision has provided a short-term boost to confidence that is likely to delay the slowdown in demand that will be needed to limit pressures from demand and inflation.

The key for central banks at this point in the inflation cycle is to slow aggregate demand, including demand for labour, so companies are wondering if their recent successes in raising their prices, in particular to restore their margins, can be maintained or if they can continue with their plans to increase prices.

Without this hesitation, the RBA will fail to extract inflationary pressures from the system.

Questioning the sustainability of demand will also be consistent with questioning the need to relaunch employment plans, at a time when the labor market is the tightest for 50 years. Currently, labor supply cannot adjust fast enough to contain wage pressures – so labor demand must slow.

Tight labor market conditions have emerged during the pandemic, associated with the “closing” of national borders – with restrictions on the entry of people (labour supply) stricter than those on exit. Net immigration averaged around over 240,000 before Covid and in the two years of the pandemic Australia saw outflows of around 120,000 – a net loss of around 600,000 people. This was at a time when fiscal and monetary stimulus was boosting demand, worsening the lack of jobs.

The third unintended consequence of the RBA surprise was another unexpected collapse in the AUD to around $0.625 from $0.65 before the announcement.

This can be expected to put additional pressure on inflation, adding upside risks to the RBA’s current forecast of 7.75% by the end of 2022 and, potentially, to its forecast for 2023. .

And the fourth unintended consequence is that a decision to accelerate rate hikes to 50 basis points would now be particularly dangerous.

Just as we have seen confidence overreact following a positive shock, the impact of a larger than expected tightening is likely to be too damaging from an RBA perspective.

The RBA hasn’t ruled out going back to 50s if the data dictates, although we think the hurdle to get to 50 now will be very high.

At the time of the announcement, we interpreted these likely unintended consequences as not warranting any change to our 3.6% terminal rate, but extending the duration of the tightening cycle.

We have extended our estimate of the end of the tightening cycle from February to March.

As noted, this would be consistent with activity holding up longer given the renewed confidence in the political pivot.

Therefore, we now expect moves of 25 basis points in November; December; February (no meeting in January) and March.

We still expect that reaching a terminal rate of 3.6% will be enough to slow economic growth from 3.4% in 2022 to 1.0% in 2023.

Activity could hold up a little better in the first half of 2023, given a little more dynamism in 2022, resulting from the lower rate profile, followed by a more rapid slowdown in the second half.

Any risk of consecutive quarters of negative growth would focus on the second half of 2023 rather than the first half, although this “recession” scenario is not our central case.

If our four percentage point drop in inflation in 2023 does not appear to materialize (and this must be a central risk), we expect the RBA to raise the terminal rate further – certainly a more likely scenario than trying. to adjust inflation with a more favorable rate cycle and stronger growth.

The role of the neutral rate

In our view, the central bank’s “playbook” is that when it becomes necessary to contain an inflationary shock at the same time as policy is clearly stimulative, the strategy is to quickly bring the cash rate back to “neutral” and then to slow down.

In previous speeches, the RBA Governor has identified “neutral” as at least zero real, where the nominal component is best valued as long-term inflation expectations – around the policy target of 2.5% .

The guideline we have worked with is a neutral minimum of 2.5%.

The cash rate is now 2.6%, so the policy is currently in the neutral region.

On October 12, RBA Deputy Governor (Economic) Ellis delivered a major speech on neutrality measures.

She names a range of “neutrals” from negative 0.5% real to positive 2.0% real – her various patterns indicating a central tendency of around 1% real (or 3.5% nominal).

But neutral is described in terms of the long term. This is the rate that is compatible with maintaining the economy at trend growth and inflation at the inflation target.

Ellis concludes, “The neutral rate is an important guide to thinking about the effect the policy might have. It is not necessarily a prescription for what the policy should do.

This indicates that neutrality is a long-term concept while the real policy will be shaken by short-term shocks.

It’s a similar approach to when President Greenspan was asked where he saw the neutral. He responded along the lines of “I’ll tell you when we get there” or even after we get there.

Nevertheless, it now appears that the Bank has a concept of neutrality that should be about where we are today, if not a bit higher.

For other reasons we discussed above, this indicates that moving to 25 basis point moves is the most likely outcome.