WEEKEND ECONOMIST: Going up?
Markets are pricing interest rates to start rising in early 2010, putting on 100bps by year's end. We expect the deterioration of the labour force will delay this until the end of 2010 or even well into 2011.
The reversal in the headline number is partly explained by petrol which 'only' fell by 7.5 per cent compared to the 18.2 per cent fall in the December quarter. Note also that the headline measure of inflation is not seasonally adjusted and there are the normal large seasonal increases in utilities; public transport; education and pharmaceuticals which will contribute to the higher read for the headline measure.
However, we are also looking for an increase in the underlying price pressures in the March quarter. This is due to the lagged effect of the fall in the Australian dollar through the second half of 2008; the heavy discounting that occurred in the December quarter; some upward price pressures associated with retailers' anticipation of consumer spending associated with the fiscal stimulus and resilient retail deposit rates as banks competed aggressively for household deposits.
This increase in quarterly inflation is unlikely to disturb the Reserve Bank. There will still be a solid fall in annual underlying inflation from 4.7 per cent six months ago to 4 per cent. That is still outside the Bank's target zone of 2–3 per cent but it must be pointed out this fall has been achieved at a time when the AUD has fallen by around 30 per cent. With the labour market weakening and demand contracting, wage and price pressures will continue to ease through 2009. A year ago the quarterly underlying measure for the March quarter printed 1.3 per cent. The fall through 2008 in the quarterly measure to 0.9 per cent in the March quarter 2009 indicates that the required fall to an average of 0.7 per cent in the final three quarters of 2009 seems easily achievable. That would see the Reserve Bank achieve its forecast of 3 per cent annual increase in underlying inflation 2009.
Inflation data is highly unlikely to affect policy decisions through the course of 2009.
However we are perplexed by the current state of market pricing for official interest rates over the course of 2009 and 2010. Markets continue to expect that the lowpoint in the current rate cycle will be 2.5 per cent – above our current target of 2 per cent (to which we attach downside risks). That lowpoint will be largely determined by the success of the rate cuts in feeding into private sector borrowing costs. Around 40 per cent of banks' funding costs are affected by the bank bill rate but the remainder are determined by retail deposit rates (40 per cent) while around 20 per cent of funding costs are independent of market rates (capital; non interest bearing deposits).
With banks focused on growing retail deposits the lower pass through of rate cuts to private borrowing rates is to the benefit of retail depositors. We assess that retail deposit rates have fallen by only 200–250bps while the Reserve Bank has cut the cash rate by 425bps. A more modest pass through by banks as they attempt to hold up deposit rates may allow them to continue passing through rate cuts for longer allowing the Reserve Bank to consider reducing rates below our 2 per cent target.
We should not lose sight of the fact that banks have passed through around 375bps of the 425bps of Reserve Bank rate cuts. Our research indicates that housing affordability in Australia has improved by as much as has been the case in the US and UK. However 70 per cent of that improvement has been due to lower mortgage rates and only 11 per cent to lower prices (18 per cent due to rising incomes). That compares with US (51 per cent) and UK (41 per cent) where price falls have been the dominant factor. In effect, the RBA's success in reducing mortgage rates has eased downside the pressure on prices. An aggressive central bank and a strong banking system are likely to prove to be key reasons why our house prices can continue to be much more resilient to the current global crisis than has been the case in US and UK.
Our second concern with current market pricing is the timing of the up cycle in rates. Markets are currently pricing the RBA's overnight cash rate to start rising in Australia early in 2010 and be up by 100bps by year's end. We don't expect the tightening cycle to begin until near the end of 2010 or even into 2011. We expect that the period of most rapid deterioration in the labour market will be in H2 2009 and H1 2010 period when the unemployment rate could rise by up to 3ppts. We would be very surprised if the Reserve Bank saw the need to raise rates at such a tense time for the economy.
Certainly the labour market can be seen as a lagging variable but those lags can be expected to be more apparent near the end of 2010 and into 2011 when the unemployment rate is likely to still be rising albeit at a much slower pace. "Lead" variables such as building approvals; share prices; credit growth; can all be expected to have "turned" through late 2009 and into 2010 but we expect that central banks globally will favour the approach of delaying the tightening cycle as long as possible to be entirely sure that they do not disturb a fragile recovery.
For example, in the case of Australia we have already observed how important rate cuts have been to improving housing affordability and reducing the risks to house prices. A reversal of that improvement at a time when unemployment is rising quickly would risk a very painful deterioration in the housing market; deter both investors and new owner occupiers and risk a damaging negative wealth affect.
The policy of waiting longer but moving quickly to restore rates to neutral points to around a 300bp rate rise over the course of 2011. Central banks will recall the "Greenspan mistake" of only tightening in 25bp steps in 2004/05 which established a solid liquidity base to fuel the subsequently devastating housing boom.
As we move through 2009 we expect markets to gradually push out the timing of rate hikes although they will also move towards pricing in a much more rapid move back to neutral (around 5 per cent) once the tightening cycle begins.
Bill Evans is Westpac's global head of economics