WEEKEND ECONOMIST: Central bank uncertainty

The key to Australia's interest rates future may not lie in Martin Place but in the actions of central banks overseas and how those moves affect the global economic climate.

Last week we saw a very confident Reserve Bank governor make it as clear as central bankers are prepared to do that the bank is in no mood to cut interest rates in the near future. We were certainly given no reason to regret our revised forecast that rates are set to remain on hold for the next few months with the next cut not coming until the December quarter.

As testament to my views last week that market pricing is a combination of monetary policy expectations and "safe haven" sentiment, markets persist with pricing in rate cuts for the near future. Pricing implies a non trivial chance of a cut in August; an almost certain cut in September; and three by year's end.

However, for now, other central banks are dominating our attention. Both the US Federal Reserve and the European Central Bank have meetings next week.

Readers will note that the forecast tables in our regular monthly report – Westpac Market Outlook – include forecasts for the size of the Federal Reserve's and the European Central Bank's balance sheets.

Our forecast for the Fed's balance sheet has consistently indicated that the Fed is likely to expand its balance sheet from the current US$2.91 trillion to US$3.51 trillion by March next year with the process beginning in the September quarter. For this reason, we will take more than a passing interest in the results of the FOMC meeting which is scheduled for this week. We expect a version of QE3 is likely to be announced either next week or certainly following the next FOMC meeting in early September. It is likely to involve further expanding the Fed's balance sheet through the outright purchase of mortgage backed securities and/or US Treasury securities.

We also have the ECB's balance sheet forecast to expand from €3.1 trillion to €4.5 trillion by June next year. Overnight comments from ECB chairman Mario Draghi appear to point to his preparedness to embrace QE in order to stabilise sovereign bond markets. That would be consistent with our forecast of a meaningful expansion of the ECB's balance sheet over the course of the next year.

The third key aspect of our current view is that we are beginning to see evidence that those data series from China which we assess as leading – which include credit; business confidence and house sales – are stabilising and are supporting our view that the June quarter will be the low point in the Chinese growth cycle.

These big picture factors can be summarised around our views on bulk commodity prices (coal and iron ore). Bulk commodity prices are down around 35 to 40 per cent from their peaks in 2011 and we expect will fall a further 5 to 10 per cent through to the December quarter.

However, with the Chinese data showing further evidence of turning, we expect bulk commodity prices to find a bottom in December. Through 2013, we expect bulk commodity prices to enter an upswing phase with prices rising by around 30 per cent through the year.

The turning point in the Chinese economy and the aggressive liquidity stimuli from both the US Fed and the ECB represent the key moving parts to this view.

While we expect that the stimulus in the US will really only allow the economy to maintain the underwhelming growth pace of 1.8 to 2 per cent which we expect for 2012 and 2013, the aggressive stimulus from the ECB will probably stabilise European growth which we forecast at around 1 per cent in 2012, but to be around flat in 2013.

Another effect of the boost to global liquidity from the QE policies on both sides of the Atlantic will be to directly boost commodity prices and, indirectly, emerging market growth as some liquidity flows into those economies with better immediate growth prospects. India in particular will benefit from loose global policy. Overall, we expect global growth to pick up to 3.8 per cent from 2.8 per cent in 2012.

The shock to China's export markets from the current contraction in Europe will be partially offset in China by domestic stimulus, which is likely to be more resource intensive than the export sector. Of course, the most profound risk to our core view is that the ECB is hampered in its QE efforts, or such policies buy even less time for the euro than we currently envisage. Certainly, we assess this QE approach in Europe to only be a "stop gap" and not to provide a sound basis for the survival of the euro. That next stage is likely to be a 2014 story rather than 2013.

For Australia, the expected boost to bulk commodity prices will provide a modest (at least by recent standards) increase in the terms of trade by around 8 per cent. In such an environment, the Australian dollar will remain comfortably above parity as Europe and the US seek to keep their currencies competitive.


Notwithstanding the current stand of the RBA governor, interest rates are likely to be lower in Australia by early 2013. However, from that point, there seems to be little need for further adjustments in rates as the economy responds to low interest rates and a rise in the terms of trade.

Bill Evans is chief economist for Westpac.


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