Our core view throughout this tightening process has been that the RBA assesses that growth will be restored to trend in 2010. Policy needs to be forward looking and 'emergency' rate settings are not appropriate if growth is returning to trend. The 'emergency' settings occurred earlier this year in February (100 basis-point cut) and April (25 basis-point cut). Only 50 basis points of the target 125 have been undone. With the Board not meeting in January, a December move appears timely.
That is despite the Bank having moved in both October and November and the fact that, since the Bank started announcing rate moves back in 1990, we have never seen three consecutive months when rates have been raised. The data rather than that particular precedent would be more likely to motivate a change in strategy. If the Bank decided growth might fall short of trend next year a pause in December would be appropriate. Consequently the data since the last meeting has, appropriately, been the dominant driver of expectations.
Our view is now out of line with market pricing. The market probabilities of a December rate hike have ranged from around 50 per cent on November 3 (following the release the Governor's Statement setting out the reasons for the November move) to 90 per cent following the release of the October employment data, to today's 40 per cent.
The latest shift from 70 per cent yesterday to 40 per cent today follows the market's response to the announcement of a plan to restructure Dubai World with a request for a standstill on all its debt repayments including those of its real estate affiliate, Nakheel – this saw the cost of insuring Dubai debt rose by more than 100 basis points to 429, according to credit default swap prices in London. This is a fluid situation with the government's possible options being to rely on Abu Dhabi banks. This event emphasises the ongoing fragility of the global financial system. It also supports the RBA's caution in only moving in 25 basis point tranches. However, we do not believe it will materially alter the RBA's strategy or its assessment of Australia's medium term growth prospects.
The remainder of this note sets out our thinking on the profile of market pricing as it responded to the domestic environment – in our view the prime driver of policy considerations.
The market was uncertain about December following the Governor's Statement because he adopted a decidedly more dovish stance than had been the case in his October 15 speech in Perth or the October Board Minutes which were released on October 20. The November Statement restored the key term "gradual adjustment".
The Statement on Monetary Policy which was released later in the week modestly increased market probabilities as the Bank raised its growth and inflation forecasts for 2010 although we believe its forecasts are still too conservative.
However, the run of data through the middle of the month consistently strengthened the case for a rate hike. Building approvals (up 2.7 per cent); housing finance approvals (up 5.1 per cent); business confidence (up 9 points); resilient consumer sentiment (down only 2.5 per cent despite two consecutive rate hikes); a 25,000 increase in employment in contrast with market expectations of a 10,000 loss (market was reasonably expecting a statistical pull back following the surprise increase of 41,000 in the previous month) were arguably all positive data surprises (market does not forecast confidence measures). As a result, market probabilities of a rate hike in December firmed from around 60 per cent to 90 per cent.
Up until today, issues that have traditionally generated market volatility including offshore pricing; media reports or speeches from officials played an unusually limited role in impacting market expectations. The clear message from the data was ruling market pricing.
The release of the RBA's November Board Minutes shook the market's confidence a little. The Minutes introduced the term: "The pace of the adjustment remained an open question". We believe markets correctly interpreted the word "pace" as equating with frequency so the introduction of this term raised the possibility that the Bank was planning to pause. Tightening probabilities fell 20 percentage points to 70 per cent; firmed up to 80 per cent following much stronger than expected construction data on November 25 but fell back to 70 per cent with the release of the September quarter report on business investment, which showed a 3.9 per cent fall.
Market expectations were for a 1 per cent increase in business investment, although we were not surprised (our forecast was minus 5 per cent) given the almost inevitable impact of the pull forward effect of the tax incentives supporting plant and equipment investment in the June quarter. Accordingly we do not expect that the RBA will be in any way perturbed or surprised by the business investment report.
New home sales; private sector credit; third quarter profits and third quarter inventories are all scheduled to be released on November 30 – the day before the Board meeting. The inventories data is especially significant this quarter. Over the last three quarters firms have slashed inventories in anticipation of collapsing demand. Holding inventories even steady in the September quarter will add around 1 percentage point to GDP (estimate) growth in the September quarter. This inventory contribution is likely to be required to avoid GDP printing negative in the September quarter given flat consumption and the contraction in business investment.
There is a risk that a complicating factor for the Board meeting will be a preliminary staff forecast that GDP in the third quarter (to be released on December 16 instead of the usual timing of the day after the Board meeting) will print negative. From a perception perspective such a forecast would be much more awkward for the Board if the GDP release was to be the day after the Board meeting. Public and media opinion would be much less forgiving of a rate hike if it preceded a negative print on GDP by one day.
The two-week lag will certainly ease some pressure on the Board and probably allow a forward-looking decision rather than one overly influenced by a forecast that GDP might print negative in one quarter. However, another fall in inventories along the lines of the average fall over the last three quarters ($3125 million) would certainly see the Bank substantially revising down its forecast for GDP in the third quarter.
Overall we have been much more confident about a move than current market pricing of around 40 per cent. We see the current market response to the news on Dubai as an overreaction to the likely approach from the Australian authorities. A more significant risk would be a surprise on the inventory data but the compound probability of our inventory forecast being wildly astray and the Bank responding to such a number gives it limited likelihood of having an impact on the policy decision.
Bill Evans is chief economist at Westpac.