The Reserve Bank was always likely to take a wait-and-see approach at its June meeting, but the global market turmoil has eliminated any chance of a hike.

The Reserve Bank Board meets next week on June 1. Following the last rate hike announcement on May 4 we argued that there was little chance of another rate move until the August Board meeting following the release of the June quarter CPI. Since then, of course, global market turmoil has effectively ensured that the Board will hold steady in June.
The release of the March quarter national accounts on the following day is expected to support the 'steady rates' decision with growth registering only 0.4 per cent for the quarter following 0.9 per cent in the December quarter. Private final demand is expected to contract by 0.2 per cent – the first negative since the December 2008 to March quarter 2009 period when the full impact of the GFC was seen on domestic spending with contractions in residential investment and business spending coupled with very weak consumer spending.

Overall, however, we still expect a positive for total domestic demand due to the contribution to growth from the Federal Government's school-building program. We expect growth in total domestic demand of 0.3 per cent. GDP growth is expected to be around 0.4 per cent with net exports subtracting 0.2 percentage points, inventories adding 0.2 percentage points and a small statistical discrepancy.

With uncertainty around all these last items, including total government spending, there is risk of even lower growth.

Prospects are better for the second half of 2010, with investment rebounding, residential housing investment rising as the 40 per cent increase in private dwelling approvals flow through, and households picking up their spending pace.

The Reserve Bank's economic growth forecasts for 2010-11 and 2011-12 are 3.5 per cent and 3.75 per cent respectively, so they are clearly expecting the March quarter to be temporary lull in the quarterly growth cycle.

We were surprised earlier in the week that markets reached an 80 per cent probability of a rate cut by August/September. That has since pulled back a little but we are still seeing market pricing giving a more likely prospect to rate cuts than rate hikes.

Clearly the developments in Europe are dominating market thinking. We cannot deny uncertainty and risks. Readers will recall that in late April, Westpac was the only forecaster on the standard panels of around 25 expecting rates to remain on hold for the rest of the year following a May rate hike. Our assessment was that the interest-rate sensitive parts of the economy were already slowing as rate hikes were biting (retail sales; housing finance; even employment growth).

We also expected that the May rate move would see mortgage rates reach a sensitivity point where Consumer Sentiment, which had been remarkably resilient to the previous moves, would start to react. The 7 per cent fall in the Index confirmed that view although, personally, I expected the fall to be even larger.

However, we had to change our thinking when we saw the print for the March quarter Consumer Price Index. We cannot overstate how sensitive the Bank will be to inflation risks.

It's response to the 0.8 per cent print on core inflation was to revise up its inflation forecast path to "remaining in the top half of the band over the forecast period" rather than holding around the middle of the target band.

Don't underestimate the scare the Bank received in 2008 when core inflation soared to 4.75 per cent. At the time, evidence that inflation pressures had built quickly, which culminated in the 1.2 per cent print for inflation in the December quarter of 2007, was met with consecutive February and March hikes. That was despite the GFC being well underway – recall the Fed cut rates by 75 basis points to 2.25 per cent in March and Bear Stearns was 'rescued' by the generous put option which the US Government granted to JP Morgan.

The variable mortgage rate reached 9.6 per cent – probably 250 basis points above 'normal'. So the 300 basis point rate cuts we saw in the second half of 2008 probably only pushed rates marginally below 'normal', which is where they stand today. Market fears of a repeat bout of 100 basis point emergency cuts are clearly misjudging the significance of the current starting point.

The big issue is whether we might be moving toward another 'bout' of excessive inflation pressure. That will be occupying the thinking of the RBA as the next resources boom takes hold (we expect a record improvement of $4.3 billion in the trade balance between March and April to be announced next week!).

Headline inflation reached 5 per cent in 2008 (a little more than the peak in the core of 4.7 per cent). Major contributors were core goods and services (1.7 percentage points); transport (1.2 percentage points); housing and rents (0.9 percentage points); retail bank margins (0.7 percentage points) and food (0.5 percentage points). Of course, the transport component was largely driven by the 33 per cent surge in petrol prices over the previous two years as the oil price jumped from around US$30 a barrel to US$140 a barrel – petrol would have had some indirect effects on other components as well such as food and core goods and services. Another significant indirect effect would have come from wages with the wage price Index growth rate peaking at 4.3 per cent during that period. Retail bank margins had a significant impact during 2008 while the wages; commodity prices and a shortage of rental properties were driving the blow-out in the housing component.

Looking at the recent trends in these components we note that core goods and services appears to be slowing a little mainly due to a slowing in components such as clothing; cars; household goods and entertainment. Offsetting that is a sharp increase in the costs of utilities (up 15 per cent for the year) and persistently high inflation for education and health. There is clear evidence of an acceleration in housing-related components; the food component looks a abnormally low; while the 2009 commodity boom has pressured the transport component. The current turmoil in wholesale funding markets may put renewed upward pressure on retail margins.

In summary, the absence of an ongoing surge in petrol prices; strong pressure on banks to contain retail margins; and some downward pressure on discretionary components all seem to point to the Bank successfully avoiding another inflation blow-out like 2008. However risks with housing; administered prices; and wages raise the spectre of further increases in inflation.

Absent a major global shock associated with China or total policy failure in Europe, these inflation concerns will be foremost in the Bank's priorities.

Despite market pricing we are retaining our forecast of a further rate hike in August.

Bill Evans is chief economist at Westpac

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