WEEKEND ECONOMIST: Inflation won't stop hike
Markets are unnecessarily focussed on the inflation prints next week. The run of strong recent data means a February rate hike is all but inevitable.
For example, in June last year we saw a stunning 12.7 per cent jump in the Index. It was largely ignored by the market. The market and most economists were still expecting further rate cuts with rate hikes not priced in before well into 2010.
While not as spectacular as last June, the 5.6 per cent jump in the Index which we announced last Wednesday is a stunning result. The Index has recovered all the ground it lost since the Reserve Bank began its record run of three consecutive rate hikes from October to December last year. It is likely to be signalling to the authorities that households are coping comfortably with higher rates.
Supporting that resilience are other aspects of the last Sentiment survey that tend to attract much less attention. Yesterday we released the latest measure of Unemployment Expectations. The Index indicates that households' confidence about their job security improved by 15.5 per cent to reach its highest level of confidence since 1996. The stunning improvement in the jobs data and associated job prospects has been the most important driver of overall confidence.
Today we have released an associated survey on how households view house prices. As an adjunct to our Consumer Sentiment and Unemployment Expectations survey we also survey households' outlook for house prices.
In May last year when we first surveyed this topic only 33 per cent of respondents expected house prices to rise over the next year. By October last year that proportion had increased to 74 per cent and in the recent January survey 84 per cent of respondents expect house prices to rise. Clearly, the exuberance associated with overall sentiment has spilled over to asset price expectations.
An important speech by RBA Deputy Governor Battellino on December 16 last year defined as clearly as one can expect from a central bank that the Bank's assessment of "neutral" has been lowered by 100 basis points. "With other interest rates in the economy having risen by at least 100 basis points relative to the cash rate over the past couple of years, they are now above their previous cyclical lows...Taking these considerations into account it would be reasonable to conclude that the overall stance of monetary policy is now back in the normal range, though in the expansionary segment of the range".
We do not know how wide the "range" is assessed to be by the RBA but it is reasonable to assume that the "range" would have a minimum size of 100 basis points and a maximum of 200 basis points.
That would put the midpoint of the "range" as 4.25 per cent (minimum) and 4.75 per cent (maximum). Previous assessments by RBA officials that neutral was around 5.5 per cent fits neatly into a new neutral of 4.5 per cent – that is, 100 basis points below the previous neutral and reflecting the increase of 100 basis points in the margin between the cash rate and private rates.
The survey evidence set out above coupled with the ongoing positive news on the labour market suggests that the Bank will be keen to move the cash rate back to the new neutral fairly quickly – certainly by June this year.
We think markets are unnecessarily focussed on the inflation prints next week.
We believe that next week's inflation prints will be largely irrelevant to the near term prospects for rates.
We expect underlying inflation to print 0.7 per cent next week. That will push annual underlying inflation down from 3.5 per cent to 3.4 per cent – above the Bank's current forecast of 3.25 per cent for underlying inflation in 2009. Such a result would, of its own right, support a rate hike on February 2.
However, our forecast might be on the 'high side' given that despite a 6.6 per cent increase in the import weighted AUD trade weighted index on average over the quarter we are only expecting price reductions across most of the imported goods sector (around 10 per cent of the CPI in total) of 1-3 per cent.
We may also be underestimating the indirect effects of the 3.4 per cent fall in petrol prices.
However, we continue to see upside pressure from those large components which in addition to petrol tend to explain most major fluctuations in the CPI: housing costs (8 per cent of CPI); rents (6 per cent of CPI); motor vehicles (4 per cent of CPI); and financial and insurance services (9 per cent of CPI).
This general theme reflects our view that solid demand conditions will maintain pressure on prices – particularly services.
If we did see a rogue low print on underlying inflation the RBA is still very likely raise rates on February 2.
Recall that by the Bank's own admission rates are "in the normal range though in the expansionary segment of that range".
The Bank is likely to be currently giving much less emphasis to inflation than was the case in the last tightening cycle, particularly when rates are below neutral.
Arguably the Bank's most regrettable decision on rates in recent times was to be too influenced by what turned out to be two 'rogue' low CPI prints in December 2006 and March 2007.
Despite very strong data the Bank chose to keep rates on hold between November 2006 and August 2007. Strong lagged increases in underlying inflation over the next 9 months elicited another 75 basis points of rate increases to levels well above neutral (around 200 basis points above neutral) even as the global financial crisis was building (the last rate hike came in March 2008 – the same month that Bear Sterns collapsed into the 'government guaranteed' arms of JPMorgan.).
In retrospect it seems likely that the Bank would have preferred to have raised rates at a faster pace during 2007.
Given the current level of rates and the strength of the current data series it is very hard to envision a CPI next week that would see rates being on hold.
Bill Evans is chief economist at Westpac.