CPI Seals Another Rise

Expect interest rates to rise again next week. Economists say that the Reserve Bank of Australia (RBA) will respond to today’s inflation figures by voting for another rate rise at next week’s meeting, and that more rises in the near future are a distinct possibility.

The consumer price index figures released by the Australian Bureau of Statistics showed a rise of 1.6% for the June quarter, well above the 1.1% forecast. The figures lifted the annual rate of inflation from a predicted 3.5% to 4% '” outside the RBA’s target range of 2–3%.

The biggest contributors to the rise were increases in the cost of petrol and fruit, up 11% and 52% respectively. Increases in the cost of fruit have been attributed to the devastation caused by Cyclone Larry which destroyed banana crops and pushed banana prices up 250%.

Medical services rose by 4%, which contrasted to a 2.6% fall in electronics goods and a 2.1% fall in the price of women’s clothing.

The increases in the cost of specific items are not especially important; however, any evidence that producers are passing on costs to consumers would make a difference. Crucially these figures offer no evidence of such a trend.

On balance, leading economists expect another incremental rise will be enough to tap the economic brakes, and that a large rise will be unnecessary.

Stephen Koukoulas, chief strategist, TD Securities

The CPI locks in the interest rate rise from the RBA next week and will keep speculation building that the RBA will need to hike well beyond that before it can be confident that inflation is on track to fall within the target range. The inflation result has arrived at a most uncomfortable time for the RBA. Global inflation is picking up, labour market tightness is adding to future wage and inflation pressures, tax cuts have boosted consumer sentiment and spending, housing is on the rise, credit growth is strong, pipeline price pressures (the PPI) are high and accelerating and global conditions are buoyant. Since the March quarter 2004, the annual inflation rate has accelerated from 2.0% to 4.0% '” a rise of 200 basis points.

This is why we are sticking to the call that the RBA will increase interest rates in August and again before year-end, bring the cumulative tightening cycle to eight rises and 200 basis points of hikes. In other words, current interest rate settings do not sit with a scenario where inflation will ease back to within the target range. Indeed, market expectations of a 6.25% cash rate by late 2006 / early 2007 could be further increased if we get evidence of strong growth and building wage pressures in the months ahead.

Craig James, chief equities strategist, CommSec

The underlying inflation rate remains low. Excluding volatile items, prices rose by 0.6% over the quarter and 2% over the year. Inflation is being driven by factors outside the RBA's control, but it cannot afford to take chances. We expect the RBA to lift the cash rate by 0.25% next week.

But inflation is far from galloping away in Australia, with just a handful of factors driving the cost of living to 11-year highs. Strip out petrol and fruit and the rate of inflation is closer to 2.5%, well within the RBA's target zone.

The Reserve certainly won't be throwing out the baby with the bathwater and jacking up interest rates markedly. While a 0.25% rate hike will most likely be delivered next week, it’s not because there is strong economic justification for a move, but because the RBA would be sending the wrong message if it doesn't lift rates.

The bank must talk tough and act tough to preserve its great track record on inflation. A small interest rate hike will certainly lead to a weaker economy but it is just the insurance policy required to prevent inflation from remaining high and causing interest rates to rise more markedly in the future.

Dr Ron Woods, head of investment strategy, Challenger

It seems a near certainty but an interest rate rise next week would be a mistake. Nearly everyone expects it so I reckon if you’re a punter you should back a no-rate change position. If you’re not a punter then have faith that eventually the RBA will do the right thing and keep rates unchanged or be forced to reverse any imminent hike.

Let me explain why: The rate rise that just about everyone says is a certainty next week is designed to knock demand on the head. That is because they all reckon it must be demand that is causing prices to grow by 4% over the year to June. But that is not correct.

It’s supply that’s the problem, not demand. Slapping down demand could see the economy take another dive. Moreover, an RBA rate rise will only worsen supply conditions elsewhere in the economy and that could in the long run be even more damaging for the national economy. Go figure!

Gerard Minack – Morgan Stanley

Today’s higher-than-expected CPI report adds to the already-strong case for another RBA rate hike. The market is now fully pricing a 25 basis point increase, taking the cash rate target to 6%, on Wednesday, August 2. The market has also increased the prospect of an additional rate increase beyond that (in fact, a move to 6.25% cash is almost fully priced for early next year).

I agree '” there obviously is the chance of further rate increases beyond August. But don’t get carried away: monetary policy is now fairly restrictive in my view, and it won’t take many signs of deceleration in forward-looking growth indicators for the RBA to stop tightening.

In fact, the Conference Board today reported that its Australian leading index fell in May, the second consecutive monthly fall. In addition, the RBA will have one eye on global growth '” certainly it pointed to the strength in global growth as a factor behind the last rate increase '” which now seems to have passed an inflection point, particularly in the US.

The key point for equity investors is this: the RBA has either tightened policy enough to ensure slower growth next year, or it will continue to tighten until growth does slow. What’s at issue is how much further the RBA has to tighten, what’s not at issue is that growth will be slower, which is the critical point for equity investors.