The Reserve Bank board meets on Tuesday, October 6 next week. We do not expect the bank to change rates at that meeting. However, we do expect the associated statement from the governor to set the scene for a tightening at its next meeting on November 2.
Markets have intensified speculation that a move could come as soon as next week. Given that the next move would be the first in a cycle that is leading the world by a year or more there are no real urgencies for the bank. By next month there will further information about the inflation outlook with the print of the September quarter data. That is likely to provide the bank with a strong specific case to move rather than 'the emergency has passed'. Given that the September board minutes emphasised ongoing "uncertainty" we do not believe that the data flow since that meeting has been sufficiently overwhelming for the bank to revise its careful, cautious approach to preparing markets and the community for this first move.
The inflation report will be released on October 21. Recent prints on quarterly underlying inflation have been: 1.2 per cent (third quarter 2008); 0.7 per cent (fourth quarter 2008); 1.1 per cent (first quarter 2009); 0.8 per cent (second quarter 2009). We are expecting 0.8 per cent for the third quarter of 2009 which will lower the annual rate to 3.5 per cent from 3.8 per cent but a 0.5 per cent in the fourth quarter of 2009 would be required to achieve the bank's 3.25 per cent forecast for 2009. Given the 'run' of quarterly numbers, that seems a big stretch, and the bank could easily justify a rate hike on the grounds that inflation is not slowing as rapidly as it had previously forecast.
We expect the RBA to raise rates by 25bps in both November and December but unlike current market expectations which indicate the cash rate to reach 5 per cent by early in the second half of 2010 we expect the peak in rates in 2010 to be around 4 per cent with the bank likely to be pausing over the second half of 2010.
Our GDP forecast of 4 per cent growth through 2010 has been predicated on a cash rate peak in 2010 of 4 per cent. We are not changing our growth forecast. In bringing forward the beginning of the cycle we really only expect the pause to come somewhat earlier.
On the demand side a variable mortgage rate of 6.5 per cent (around 100bps from current levels) is likely to sufficiently deflate Consumer Confidence and housing credit demand to signal the need for a decent pause in the hiking cycle. On the supply side we expect difficult global financial conditions to constrain the supply of credit ongoing in Australia.
This change brings forward our original timing of the first move from February next year to November. We have been forecasting through the year growth in 2010 of around 4 per cent for some months with consumer spending; an improving outlook for business investment and the surge in government spending being key drivers. However we expected that the evidence around the consumer in particular would remain uncertain for some months.
August retail sales important
The case for an earlier than expected tightening has been significantly strengthened by the release of the August retail sales data.
In the Minutes to the September board meeting it was noted that a deal of uncertainty existed with respect to the economic momentum. For us, the key area of uncertainty related to the momentum of the consumer. Consumer sentiment had reached levels normally associated with a consumer boom. However, other aspects of the survey were sending a more opaque message. In particular consumers' investment preferences remained very conservative. Nearly 60 per cent of respondents favoured "pay back debt" and bank deposits over other investments such as equities and property – that conservatism has not been associated with previous consumer booms.
These factors are likely to see a more subdued consumer than associated with 'boom' conditions. That said, the tone of the August retail sales is now falling into line with our base forecast of 3 per cent growth in consumer spending through 2010. That is consistent with our 4 per cent overall growth forecast and would give the bank more confidence to start the rate hike cycle earlier than we previously expected.
Up to August we had seen two very weak reads on retail sales –0.9 per cent in July and –0.8 per cent in June. Our interpretation of those numbers was that even after allowing for the correction for the withdrawal of the 'cash splash' from the government there was no evidence that underlying consumer spending was on the upward trajectory that would normally be associated with the current level of Consumer Sentiment.
The very sharp rise in retail sales in August is now convincing evidence that underlying consumer spending is very likely to be showing a cyclical upturn. While only one month's data, it will
probably be sufficient to clear up any doubts at the RBA that the strong levels of Confidence are indeed indicating a recovery in consumer spending.
The data over the next month is now unlikely to change the near term interest rate outlook. The bank seems convinced that the unemployment rate is likely to peak in "the sixes" (compared to our forecast of around 7.5 per cent) so the employment release on October 15 would need to be a most unexpected 'shocker' to change that benign outlook for the labour market.
Financial conditions still difficult
One reason why we think there will be a significant pause in the cycle in the second half relates to financial conditions. Due to the lingering constraints from the global financial crisis some
credit aggregates are not already performing in the normal way associated with 'emergency' interest rates.
Businesses do not find rates at 'emergency lows'. Business credit has contracted by 2.2 per cent in the year to August compared to an increase of 17 per cent in the previous year. When businesses renegotiate their facilities they are finding that due to the widening of credit spreads margins have increased – RBA's Financial Stability Review estimates "100–200 basis points for new large business loans and around 135 basis points for new small business loans". Many businesses would argue that these "averages" are conservative. As more businesses renew existing facilities margins will continue to widen offsetting a considerable part of the benefit of these 'emergency' level rates.
The key 'measure' of whether the economy is reflecting these 'emergency levels' must be housing credit. Housing credit growth has been subdued at 7.4 per cent down from 9.1 per cent last year) but this has reflected the decisions by existing borrowers to use the rate cuts to pay down capital at a faster pace by not opting for a lower interest payment. This reflects uncertainty with the current economic environment and rising unemployment. Anecdotal evidence points to up to 80 per cent of existing borrowers being 'ahead' on their interest payments.
The strength has been in housing finance approvals – new housing loans. The number of new loans to owner occupiers is up by 38 per cent from its low last August. While heavily influenced by the 77 per cent rise in loans to First Home Buyers, lending to Upgraders has climbed 26 per cent in 2009. Significantly, investors, who explained nearly 50 per cent of new lending at the peak of the last housing boom in 2003 are up by only 5 per cent since last August. Credit conditions are currently part of the explanation behind this unusually muted response of investors to the 'emergency rates'.
Tighter lending standards; uncertainty about prices; the prospect of rising rates; and limited supply of appropriate investment properties are all roadblocks to prospects for a strong investment upswing. For investors 'emergency interest rates' are only one factor – prospects for the others are not that encouraging. Indeed the buoyant story for new finance is starting to fade somewhat. Values have been down in the last 2 months and industry data is indicating another negative in August. The number of loans to First Home Buyers fell by 7.3 per cent in July and while we can expect a boost in September the ongoing strength in the approvals data will depend on the confidence of investors and upgraders as First Home Buyers retreat.
House prices – demand/supply balance
Finally, we come to house prices. There is clear evidence that house prices are now rising (up 17 per cent annualised in the last six months). This may be another example of the impact of 'emergency' rate settings. However there are a number of other complicating factors. Prices are driven by the gap between demand and supply. Interest rates can affect demand but will have little impact on supply. We would argue that the inertia of supply (national housing completions are running at around 130,000 per year compared to underlying demand of 190,000) has been a significant factor in the current upswing in prices. The bank would argue that over-stimulating demand in the face of rigid supply is inappropriate and does provide a case for tightening. However as rates rise this argument will quickly lose its relevance as the stimulus to demand fades and it becomes solely the inertia of supply which is driving prices.
Global growth to underperform market expectations
Our relative pessimism about the pace at which global financial conditions will improve to ease the pressure on banks and eliminate credit supply as a constraint to recovery is partly based around a much less up-beat outlook for the US economy than is currently factored into markets.
Balance sheet constraints and uncertain employment prospects are likely to contain any decent recovery in US consumer spending which is the key to a sustainable recovery in the US economy in 2010. On the supply side we expect that banks will remain capital constrained; push ahead with plans to deleverage and be wary of credit risk in the consumer sector. Equity and credit markets are likely to react adversely to these developments from the first quarter of 2010. That should see a solid reversal of the current risk appetite trades providing a break on the current surge in the Australian dollar.
Revised view on AUD
Constraints on bank funding which are largely determined in the global markets are likely to remain significant headwinds to a rapid return to 'normal' cash rates. With only limited further easing of global financial conditions through 2010 banks will remain constrained in their flexibility to finance a stronger recovery. Softening demand and constraints on supply will mean that a 4 per cent cash rate will seem much less stimulatory than in past cycles and lay the foundation for a pause in the second half of 2010.
We had been expecting a fall in the Australian dollar through to year's end as markets became disappointed that the RBA delayed rate hikes until February. With rate hikes now being delivered that correction to the Australian dollar will no longer occur. Our other basis for the Australian dollar to correct related to our subdued view on the growth profile for the US economy. Our anticipated growth correction is now more likely in early 2010 than second half of 2009 since the stimulus from the recovery in the inventory cycle and government payments should sustain decent US growth momentum through 2009.
The 5–10 big figure correction in Australian dollar is now more likely in the first half of 2010 before resuming its upswing as US markets price in a more realistic recovery profile for the US economy.
Bill Evans is chief economist at Westpac.