The Statement which the Governor released at the time of the decision included a slightly more positive assessment of the economic outlook than had been the case at the time of the previous rate hike in November (house prices; government spending; household wealth).
However our assessment of the tone of the Statement, including referring to "material adjustments" (three consecutive rate hikes) indicated that if there had been a Board meeting in January the Bank would have paused at that meeting. With no meeting scheduled for January the pause will certainly be enforced.
Markets have moved quickly to price in a profile for rates in 2010 much closer to our view than had been the case over the last few months. We have consistently argued that ongoing uncertainties in the global capital markets; disappointments in the pace of recovery in the major economies (Europe; US and Japan); some difficulties with the availability of credit in the domestic market; and sensitivity of the household sector to a variable mortgage rate around 7 per cent would move the RBA into a holding pattern for much of 2010.
We assessed a peak in the cash rate of 4.5 per cent by the middle of 2010. In contrast, markets had been consistently pricing in a peak in the cash rate of 5.25 per cent – 5.5 per cent through to end 2010. As recently as last week a poll of 21 economists showed that 13 expected rates to reach 5 per cent – 5.5 per cent by end 2010 while another 6 expected the rate to reach 4.75 per cent. Only 3, including Westpac, expected rates to peak at 4.5 per cent or below.
Markets have now scaled back the assessed peak in 2010 to around 4.9 per cent – still, in our view, too high.
We are expecting a major test of the rate view with the release of the Westpac Consumer Sentiment Survey next Wednesday. Experience over multiple interest rate cycles is that the Consumer Sentiment Index can provide the first signal of a major change in the interest rate outlook. Recall, most recently the June reading of the CSI. To the surprise of all the CSI surged by 12.7 per cent – the second largest increase in the CSI since 1975. Households took great heart from the positive GDP print for the March quarter indicating that Australia had escaped a technical recession (two consecutive negative GDP prints).
At the time markets were not expecting the RBA to begin raising rates until well into 2010 while the median forecast from 20 economists was that the cash rate would be 2.75 per cent by end June 2010 – that is, the next move was likely to be down (from the 3 per cent at the time) and rates would certainly not be rising in the foreseeable future.
As usual when the CSI has printed a significant result, markets and economists have taken considerable time to adjust to the message.
There are many other spectacular examples over the last 15 years of the significant early signs from the Consumer Sentiment Index.
Recall in December 1994 when markets expected a further 200 basis points of tightening over the next six months but the 9 per cent fall in the CSI signalled no further need to tighten conditions and, indeed, the next move by the RBA was actually an easing in August 1996. Recall the 5.3 per cent fall in the Index over November/December 2003 in the face of two RBA hikes, with markets expecting at least two more hikes. In the event the next hike was not until March 2005. Markets were convinced that there would be a follow up move in April 2005 but in response to the 15.5 per cent fall in the CSI in March there was no follow up move; domestic pressures eased and the next hike was not until May 2006. Average falls of 10 per cent in response to the three rate hikes in 2006 undoubtedly contributed to the RBA's drawn out tightening cycle during that period.
We do not forecast the monthly moves in the CSI but it is reasonable to expect a significant fall. After the first rate hike in this cycle the CSI actually
increased by 1.7 per cent only to be followed by a 2.5 per cent fall following the November move.
A third consecutive rate hike is new territory for the CSI. In addition, there is no way of assessing the extent of the impact on the CSI of the decisions by the two dominant banks in the domestic home loan market (Westpac and CBA) to raise their variable mortgage rates by more than the RBA's 25 basis point move (Westpac 20 basis points; CBA 12 basis points).
The impact also needs to be assessed in the light of the extraordinary developments on the deposit front, with some banks (also including Westpac) now offering 6.8 per cent on one year term deposits – 230 basis points over the one year swap rate! To the extent that depositors have any influence over the CSI there will be some offsetting optimism associated with these extraordinary developments.
In net terms however it is likely that these moves will still further dampen Confidence.
The likely fall in Confidence coupled with the impact which the sharply higher rates will have on demand will put a real question mark on whether the RBA pauses in February as well. We will reserve our final call on that outcome for the CSI result. However it looks likely that we will look very seriously at a pause in February.
Westpac's explanation for their 45 basis point move included the observation that wholesale term funding costs are approximately 80 per cent higher than a year ago. With Australia's major banks all similarly rated at AA similar pressures are affecting all major Australian banks. This increase in the cost of funding which, as intermediaries, banks are generally obliged to eventually pass on, reflects our concerns with the impact on the Australian economy of the failure of global capital markets to return to the 'health' of the first half of 2006 and 2007.
Australia is a country with 'world class' foreign debt (53 per cent of GDP – exceeded only by New Zealand in the OECD). As the government sector has consistently run surpluses it has been the responsibility of the private sector and specifically the banks to fund the debt.
We are retaining our view that the RBA will raise rates again in February by 25 basis points subject to the outcome from the CSI on Wednesday. A substantial fall in the CSI will see a revision to our February view and, potentially, an even lower forecast rate peak in 2010 than the current 4.5 per cent.
Bill Evans is chief economist at Westpac.