RBA risks a recession but feels there's nothing else it can do

Monetary policy trade-offs are getting worse — the Reserve Bank of Australia is confronting rising inflation and downgraded growth forecasts. And there's nothing it can really do about it. Despite this, the RBA has nonetheless decided to whack borrowers with another interest rate rise, taking the cash rate back to its post-COVID high of 4.35 per cent. In the circumstances, the bank is trying to make the best of a bad situation. The narrow path it is now walking is keeping longer-term inflation expectations in check while trying not to tip the Australian economy into recession. Today's decision is most definitely one that leans over the precipice of recession to avoid the flames of inflation. The good news is that, under its so-called baseline scenario, the bank is not expecting to fall off that cliff. In its quarterly Statement on Monetary Policy (SMP), it forecasts economic growth will bottom out at 1.3 per cent for the year to December and remain stuck at that level through the year to June 2027. Unemployment is expected to peak around 4.7 per cent, up from 4.3 per cent currently. Recession a real risk under 'adverse scenario' The bad news? That baseline scenario is based on the Strait of Hormuz starting to reopen within the next few weeks, which is also what most market traders are betting on. However, the RBA has modelled two adverse scenarios in which the strait remains closed longer. In the worst of those, economic growth is expected to bottom out at an annual rate of less than 0.5 per cent, with unemployment climbing above 5 per cent. Annual growth that weak raises the significant risk of two consecutive quarters of economic contraction — the common definition of a recession. It must be emphasised that this is not what the RBA expects to happen, which is represented in the baseline forecast. Then again, the day the RBA forecasts a recession, you know you're probably already in one. All the bank's forecasts are based on market pricing on interest rates, which currently expects a bit more than one extra 25-basis-point increase, ultimately taking the cash rate to 4.7 per cent. Even at 4.1 per cent, the RBA acknowledged the cash rate was near the top of estimates of the so-called neutral rate — one which neither stimulates nor restrains the economy. At 4.35 per cent, there is little doubt that the Reserve Bank has its foot firmly planted on the economic brake pedal. Are rising fuel prices doing the job of a rate rise? While it's undisputed that increasing fuel costs have been a financial burden for many households, the RBA says the impact for most has been less than it might appear. "The additional spending on fuel since the start of the conflict amounts to less than 1 per cent of total household income over that period, although for some households it will be a higher share," the SMP observed. In other words, rising fuel costs are not really doing enough to lower demand and bring it in line with the economy's currently constrained capacity to supply. The fuel excise cut is estimated to have taken about half a percentage point off inflation in April, relieving some of that pressure on household budgets. The RBA's forecasts assume that the excise cut will end, as currently slated, at the beginning of July. The Reserve Bank also observed that most households and businesses were not yet showing signs of severe financial stress, even though they were becoming very worried. "Consumer and business sentiment declined notably in March and April, but timely indicators do not suggest a sharp slowing in real household consumption," the SMP noted. Although some of that spending has been redirected away from discretionary goods and services, such as travel, towards essentials, such as transport, including a surge in electric vehicle purchases. In another positive, a recent Macquarie University business study found that while input costs were expected to rise about 10-15 per cent over the coming year, a little under one-third of that was expected to be passed on to end customers. "Many firms noted competitive pressure as a key constraint to fully passing on upstream cost increases, but this would be less so if price increases became more generalised across other firms and industries," the SMP noted. What the Reserve Bank has effectively done with three consecutive rate rises is to add another layer of competitive pressure, by clamping down on household budgets, to ensure that price increases won't become more generalised. The risk is that the tourniquet on the economy will not only stop price rises bleeding through, but amputate large sections of businesses and the community in the process.