WEEKEND ECONOMIST: Moving on up
With the mid-week drama caused by the European debt crisis now fading, the door is open for the RBA to raise rates next week.
Market disturbances during the week due to the developments in European financial markets had the potential to delay such a move. Indeed in our note on the CPI we commented: "The lessons from the surprise pause in February which was, we believe, significantly influenced by the surprise developments in Greece, probably signal that with rates so close to the normal level the Bank can afford to wait until June. If the European crisis settles to the satisfaction of the markets over the next few days then the way would be clear for a May move".
Over the last two days markets have indeed settled. Credit spreads have contracted by around 10 basis points; volatility (the VIX) is down by 20 per cent; US and European equity markets have risen by 1-2 per cent and AUD is up from USD 91.40¢ to USD 93¢.
Two days ago there were genuine risks that markets might have continued to deteriorate sharply rather than find the stability we have seen. Under those circumstances the prudent option for the Bank would have been to delay any rate hike. Now it has an acceptable window to restore rates to the 'normal' level.
We have always argued that 'normal' is 4.5 per cent. In the Governor's speech on April 23 he commented: "If the economy is growing close to trend and inflation is close to target one would expect rates to be pretty close to average"....."rates are now pretty close to that average". If these comments are relevant to rates at 4.25 per cent then 4.5 per cent should achieve the 'normal' target.
Of course, our case for a May move has been strengthened by the print of the trimmed mean and weighted median quarterly inflation measures. The quarterly trimmed mean increased from 0.5 per cent in the December quarter (revised) to 0.8 per cent in the March quarter and the weighted median rose from 0.6 per cent to 0.8 per cent. Recall that in previous speeches and reports, the RBA has referred to the quarterly annualised core measures indicating that underlying inflation was now running at a pace that was comfortably within the band. The quarterly number in the latest report means that comfort is no longer available, with 0.8 per cent per quarter annualised being above 3 per cent.
This unwelcome deterioration in the trend in the quarterly underlying inflation measures increases the urgency to restore rates to normal.
The developments on the inflation front are by far the most threatening to our view that the Bank, once it has reached neutral, will keep rates on hold for the remainder of the year.
Our argument has been that the economy will be facing a range of headwinds through the course of the remainder of the year.
1. The cumulative effects of six rate hikes in only seven months.
2. The switch from aggressively expansionary fiscal policy to contractionary fiscal policy as the $42 billion fiscal stimulus package fades. The main channel through which the 70 per cent boost to the terms of trade from 2003 to 2008 lifted demand was fiscal policy – much more of these fiscal dividends will be used to reduce debt in this cycle given the different starting points of the Commonwealth's budget.
3. Evidence that the consumer is much more cautious with a sharp increase in their preferences to pay down debt.
4. Evidence that the interest rate sensitive parts of the economy are already slowing.
5. Significant question marks about the global economy – China is slowing; US growth 'recovery' is being exaggerated by the current impact of the fiscal stimulus and the inventory cycle; the shock to confidence in financial markets from the current issues surrounding Greece is likely to restrain recovery through 2010.
6. Funding issues and regulatory uncertainty will continue to constrain the banks' capacity to support credit.
7. The sharp increase in population growth and associated increase in labour supply (including likely rise in the participation rate) are likely to contain the fall in the unemployment rate, particularly with the recent pace of jobs growth slowing.
8. RBA policy towards house prices is not to contribute to the recent (justified on the basis of population growth and limited supply) increases in house prices developing into a speculative bubble – that requires policy to be neutral rather than expansionary – with next week's move to neutral policy unlikely to be targeted at house prices.
All these arguments gave us comfort that our call for an extended period of stable rates was reasonable.
It certainly still supports a strong case for stable rates until the release of the next CPI – in late July. The next 'live' meeting would therefore be expected to be August.
Our preliminary call for the next quarterly trimmed mean measure of the CPI is 0.7 per cent. That would be a step down from the 0.8 per cent registered in the March quarter. Factors associated with the strength of the economy would then be most relevant for RBA deliberations as to whether the "0.7's" could be sustained or whether there would be a renewed step up.
Now that the CPI has become an issue earlier than expected, we are not as confident that rates will remain on hold through the rest of this year after the May hike. The RBA's record in the last tightening cycle was fairly uniform.
Once rates got to 'neutral' (December 2003) they never tightened when the trimmed mean was 0.6 per cent or lower (seven readings); there were four reads of 0.7 per cent with two tightenings and two 'on holds'; any read of 0.8 per cent or above (five readings) was followed by a rate hike.
That record means that our preliminary forecasts of "0.7 per cent" for the trimmed mean in both June and September quarters make August and November very much 'live' events.
At this stage we are still convinced that our list of headwinds noted above will bring the decision down on the 'pause' side but recognise that with this lift in the CPI in the March quarter, our call for stable rates just got a lot riskier.
Statement on Monetary Policy
The key issues we will be following in the Statement on Monetary Policy which will be released on May 7 will be around the Bank's forecasts for growth and inflation.
Recall that in the February Statement the Bank forecast GDP growth in 2010 and 2011 at 3.25 per cent and 3.5 per cent respectively. Underlying inflation was forecast at 2.5 per cent and 2.75 per cent respectively. The Bank has already noted in other Statements that it has raised its terms of trade forecast significantly.
That is likely to lead to a growth forecast increase to 3.5 per cent in 2010 and 3.75 per cent in 2011. We assess that the Bank expects that 'trend' growth in the economy is 3.5 per cent, a slightly 'above trend' growth rate would be expected for 2011.
With the starting point for underlying inflation in 2010 as 0.8 per cent, maintenance of the 2.5 per cent forecast for underlying inflation in 2010 would require two quarters of 0.6 per cent and one 0.5 per cent for underlying inflation. That is unlikely and more likely the forecast will be raised to 2.75 per cent implying a mix of 0.6 per cent's and 0.7 per cent's. It is unlikely to raise the 2011 inflation forecast from 2.75 per cent – recall these forecasts are based on appropriate policy so we won't know whether the Bank expects to need to raise rates further to achieve the target or not.
The choice of a slightly above-trend growth rate in 2011 leaves the door open for rates to go above 'normal' although the forecast is still so close to trend that it is not really signalling a clear policy intention. If however the Bank were to forecast 4 per cent growth in 2011 then a clear expectation that rates will have to rise further will be implied.
Bill Evans is chief economist at Westpac