Interest Pressure Builds

The release of important inflation data on Wednesday '” showing inflation was a little higher than long-term averages '” triggered a new round of debate among leading economists over the future direction of economic policy, especially interest rates. The data, Melbourne Institute's measure of consumer inflation expectations for January, was 4.6%, 0.4 percentage points above the average of the past 10 years. However, the numbers were by no means worrisome, coming in well below the peak of 5.1% reached in early 2005.

Most economists read the inflation figures as a positive signal for the economy, indicating a lively market where prices are still being contained. Economists also believe the numbers could indicate a firmer GDP figure this year, ultimately increasing the prospect of higher interest rates in the second half but not any earlier..

As Dr Ron Woods, the chief economist at Challenger Economics, suggests, the containment of consumer prices is no surprise, yet many commentators still expect the Reserve Bank to continue increasing rates. As Woods wrote in a recent report:

Most market commentators have been perpetually warning of more interest rates because “inflation” (as they call it) was going to accelerate. These naysayers, and there have been many of them, have largely always been wrong. In the latest (inflation) data core consumer prices rose by 2.3% in the year, down from 2.4% three months earlier, to remain comfortably within the RBA’s 2–3% target band.

Somehow, without independent analysis it would seem the inflation pessimists just blindly accepted the Reserve Bank’s rhetoric that there were going to be more rate rises. But that seemed unlikely when the housing frenzy faded in late 2003 and the economy’s major source of domestic growth waned, too. But worse, the housing frenzy had also distorted the domestic economy, especially the pattern of job creation towards housing. It also fuelled the country’s appetite for imported fixtures and fittings and other consumables, to the point that Australia still ran a trade deficit even during an export boom in resources.

To add to the woes, and almost reminiscent of what happens in so many Third World resource-rich countries, despite that mineral wealth, male unemployment is now rising (after taking into account the usual seasonally factors, between July and December 2005 the number of males looking for full-time work rose by nearly 24,000). With such an unhealthy economic structure, any predictions of higher consumer prices and higher official interest rates to quell them have been wide of the mark.

Interestingly, though inflation is subdued, Citigroup economist Shane Lee points out that price rises are moving at different speeds in different cities across Australia. As Lee suggests: The capital city breakdown provides further evidence of the impact of the terms of trade on aggregate income and demand. Inflation in Perth (4%), Darwin (3%) and Brisbane (2.8%) is running ahead of the average in Sydney and Melbourne (2.6%).

Rory Robertson, the fixed interest specialist at Macquarie Bank, is also sanguine on the inflation figures, although he agrees with Woods that unemployment figures will be crucial to future policy settings:

Whatever the (modest) acceleration in economy-wide wages growth over the past year, it remains hard to argue that it is causing any real problems on the inflation front.

As long argued here, the trend in unemployment tends to provide a good guide to future RBA policy. That's because a fall in unemployment promotes growing wage and price pressures, and vice versa. Unemployment has held pretty steady near 5% since the sharp drop from 5.5% to 5% over the fourth quarter of 2004, which that helped spark the RBA's hike last March. And that's been a key factor keeping RBA cash steady at 5.5%.

Most recently, unemployment has edged up to 5.1% in the fourth quarter 5% in the previous quarter. Driving that was the ABS's estimate of a slight fall in the level of full-time jobs over the second half of 2005. No one believes that actually happened '” unbelievably weak jobs growth simply is reversing earlier unbelievable strength '” but any further RBA hike will have to wait at least until the ABS some time down the track reports a significant strengthening of full-time employment.

In my mind, RBA cash stuck at 5.5% into the second half of 2006 remains the most likely policy scenario.

At TD Securities, chief economist Stephen Koukoulas concludes the key economic risk now is rising interest rates, and that an increase is most likely to come after June 30. He says the following factors will be key influences on a rate rise:

• Unemployment remains near a 30-year low:
• Growth in the Labour Price Index is at a seven year high:
• Global economic conditions remain strong and global inflation is accelerating:
• Housing looks to be weak still, although the rental market is tightening and the fall in house prices seems to have run its course.

All of which, Koukoulas says, points to the RBA being either holding or lifting interest rates in the months ahead.

He says: "We (TD Securities) are predisposed to an interest rate rise before mid-year with the market wrong to be pricing in the risk of an interest rate cut."