WEEKEND ECONOMIST: Hawkish outlook

The May RBA Statement on Monetary Policy was released on May 7. The highlight was an increase in forecast GDP growth in 2011 from 3.5 per cent to 3.75 per cent and an increase in the forecasts for core inflation in 2010 from 2.5 per cent to 2.75 per cent; an unchanged forecast for 2011 core inflation of 2.75 per cent; but an increase in core inflation to June 2012 from 2.75 per cent to 3 per cent, holding there at 3 per cent in December 2012.
When the Statement was written, Thursday night's sudden dislocation of global financial markets had not occurred. Indeed, the Bank highlights the downside risks to their forecasts as "a marked slowing in the pace of growth in Asia" and/or "fiscal problems in Europe could intensify, prompting a retreat from risk taking by investors and a sharp slowing in the world economy". The Bank notes that to date the impact has been largely confined to Europe.

Excluding Thursday's developments, it was clearly a hawkish Statement. We assess that the Bank believes trend growth is 3.5 per cent, so in forecasting above-trend growth in 2011 it is implying the need to move policy above "normal levels" over the course of 2010. We were particularly surprised by the inflation forecast for 2012. A prediction that underlying inflation will have returned to the top of the target band, despite the forecast being on the basis of "appropriate policy", means that the Bank sees inflation pressures building through both 2010 and 2011.

On May 7 markets moved to price out any rate hikes for the remainder of this year. That is in contrast with recent pricing. Immediately following the rate hike on Tuesday, markets were expecting another 50 basis points of hikes by year's end.

Given today's developments in market pricing, as the only bank previously predicting flat rates in the second half of 2010, we should be particularly irritated with our change of view following Tuesday's rate hike to incorporate two moves following the July and October inflation prints. Our thinking was that although we expected that it would become apparent to the monetary authorities that the interest rate hikes were clearly biting in the interest rate sensitive sectors such as retailing, housing finance and consumer confidence, the stickiness of the inflation report, where underlying inflation was likely to be printing 0.7 per cent a quarter or higher in both quarters, would prompt the RBA to tighten further given its more bullish growth outlook than ours.

However, the events of 2008 indicate clearly that high inflation prints will not prompt a monetary policy response if a substantial global downturn coincides with evidence that rate hikes are biting. Recall that the underlying inflation measure in April 2008 and July 2008 printed 1.2 per cent a quarter on each occasion, and rates remained on hold, prior to the beginning of the super aggressive rate cut cycle in September 2008.

So, the issue is now really whether the European developments can be settled to the markets' satisfaction. With the fresh evidence of the global economic cost associated with the Lehman disaster, monetary and fiscal authorities on both sides of the Atlantic, along with the IMF, will be much more proactive in dealing with these issues and settling markets. We expect the ECB to provide strong liquidity support to the European banking system, and the US Fed to back that up with the provision of US dollar swaps. After all, the authorities bear some responsibility for this mess, given the pressure which they have put on the European banks to acquire more government paper, which was supposed to be the ultimate source of liquidity. All government paper was accepted on repo with the ECB, and therefore there was an understandable move by the banks to acquire the highest yielding government paper.

Concerns are with the value of the sovereign bonds issued by Greece; Portugal; Spain and Ireland which are held by (mainly) European banks which already have damaged capital bases. BIS data suggests that around €75 billion of Greek government bonds are held offshore by European banks. Average bond maturities for Greece are about €40 billion per year with the cumulative Budget deficits adding another €70 billion by 2014 – on the heroic assumption that the austerity package is successful in lowering the Budget deficit from 13 per cent of GDP to 3 per cent of GDP by 2014.

A rescue package of €110 billion over three years in bilateral loans has been negotiated with Euro area countries and the IMF. Markets have been unnerved by some reported reluctance of Germany to support the package. Regional elections which could lose power for the Federal government in the Upper House will be held on September 9. German support for the package is likely to solidify after the election. It is important that public opinion understand that the real issue is liquidity in the banking system not whether Greece and others are financed into further excesses.

Other countries under pressure are Portugal (net foreign debt is 100 per cent of GDP), Spain (75 per cent), Ireland (52 per cent) along with Greece (75 per cent). The issue for the European community is the risk of a liquidity crisis whereby banks do not lend to each other due to uncertainty as to their exposure to these toxic bond markets either through mark to market write downs or defaults. The damage to economies from such liquidity crises has been clearly seen as recently as 2008.

The solution must be for governments to assure markets that banks' holdings of these bonds have value. Austerity packages in the affected countries are a side-show – the funding of such associated future budget deficits does not have the same implications for financial stability; even the stability of the Euro is secondary to the need to maintain liquidity in global financial markets.

Australia is also a country with excessive net foreign debt (50 per cent of GDP). Borrowing spreads for Australian banks have increased by around 35 basis points to 125 basis points in the "popular" three-year maturity since the crisis spiralled. For the Australia Federal Government, Westpac is forecasting the announcement of a projected return to budget surplus in 2013-14 which will be very important for a small country which relies on these markets.

The solution to the Greek et al problem is clear and very expensive but "cheap” when compared to another liquidity crisis. Our forecasts assume such a solution will soon be achieved – it is unthinkable to assume anything else.

At this stage, our constructive expectation is that a sensible solution will be found to the current European financial woes, and we are therefore sticking with our views that rates will need to go above neutral in 2010. Our analysis of the Statement on Monetary Policy is that the Reserve Bank certainly has similar views, at least prior to last Thursday night.

Bill Evans is chief economist at Westpac.