Brittle ceasefire doing little to lift rate optimism
Westpac did not deliver last week’s interest rate bombshell with glee, going by fresh comments from the Big Four bank’s chief economist Luci Ellis.
In the midst of an escalating Middle East conflict, Westpac sharply revised its interest rate outlook, warning that a deeper energy shock from the Middle East conflict will push the Reserve Bank of Australia (RBA) into a more aggressive tightening cycle.
As US, Israel, Iran and its proxies exchanged blows amid US president Donald Trump’s crusade against the Iran’s Revolutionary Guard under the guise of ridding Iran of its nuclear capabilities, Westpac tipped three rapid-fire 25-basis-point hikes in May, June and August, lifting the cash rate peak to 4.85%.
This was a notable departure from its earlier call for a lower peak and earlier cuts, reflecting a darker view of the global supply shock.
Westpac argued that higher fuel and input costs are feeding through into broader Australian prices more quickly and extensively than expected, rather than being contained at the bowser.
Unfortunately, a nervous ceasefire – if indeed it can be called that – has not taken the froth off this stark economic outlook.
“The economy does not care about your feelings, so forecasts must reflect what you think is the most likely outcome, not necessarily what you wish would happen. This distinction is especially salient now,” Ellis said this Friday. “The outright fall in global fuel supply has different implications than other recent supply shocks, and the outlook for Australia and the world is rough.”
While the ceasefire was “obviously welcome”, there is no certainty over the full reopening of the Strait of Hormuz. Furthermore, a lot of damage has already been done, and higher energy prices are already being passed through to goods and services. This is what the RBA will be weighing up as it sets its interest rate course for the rest of 2026.
“The near-term outlook for Australia is tough,” said Ellis, pointing to higher inflation, a cost-of-living squeeze, lower income growth and higher unemployment.
On the bright side, Australia’s ability to leverage its LNG exports has shielded the country from extreme shortages seen in other countries, including neighbouring countries in the Pacific.
Not just any energy shock
The current energy crisis is because of a supply shock at the source.
The ongoing conflict centres on global oil and gas supply, with physical volumes not getting out of the Persian Gulf.
This is a different story from Covid-era shocks, when the damage ran “all the way down supply chains” – demand swings and logistics bottlenecks disrupted flows, but production capacity remained largely intact.
At the onset of Russia’s invasion of Ukraine, Russian oil and gas supply did not disappear, it just needed time to be redistributed to non-European nations willing to buy it despite the sanctions.
Today, net global oil output is estimated to be down around 8-9 million barrels per day and gas by around one-fifth of pre-war supply. By contrast, the peak decline in oil output during the Russian invasion of Ukraine was just three million barrels per day.
“The effect on prices from such a structural cut in capacity was always going to be severe,” said Ellis.
The key issue for Australia – and for the domestic rate outlook – is how far the energy price shock has already filtered into the broader inflation basket. Here, there is “less cause for optimism”,” warned Ellis.
While “temporary fuel levies” can be rolled back as pump prices fall, many firms have lifted list prices more permanently, making reversals unlikely.
Building materials stand out, with the cost of a detached home up as much as 10% on preliminary estimates. Price increases have been widespread and often large relative to recent inflation trends. The RBA will treat this as a further leg up in already-too-high underlying inflation.
“If the ceasefire does hold, downside risks to growth diminish and inflation risks ease,” said Ellis. “Because of the downstream pass-through to other prices we are already seeing, though, the inflation risks do not disappear and the RBA is still likely to raise the cash rate further. Still, it would be a better outcome than our current published baseline. This would be one of the instances where we would be quite happy to be wrong.”
