WEEKEND ECONOMIST: Our rates distraction

While we have been consistently forecasting a significant slowdown in US growth through the second half of 2010, we have been surprised at the response to the markets' interpretation of what that means for interest rates in Australia in 2011.

Sensibly, the US market has now pushed back the timing of the first rate hike by the Fed to December 2011. Our view has always been that the first rate hike by the Fed would be 'delayed' until the second half of 2011. That was even when the US market had around four rate hikes priced in for 2010.

The Australian markets are now putting way too much weight on US rate prospects to assess the outlook for Australian rates. As US long bond rates have fallen by around 50 basis points over the last six weeks, Australian three-year swap rates have fallen from by around 30 basis points to a remarkable 4.8 per cent. This pricing is being reflected in the very short end of the yield curve with markets now giving around a 50 per cent probability of a 25 basis point rate cut by the end of 2010.

We really struggle to describe an economic scenario that would entail the RBA cutting rates this year.

To the contrary, we think the Reverse Bank was quite prepared to raise rates at its August meeting if the June quarter consumer price index had printed around where the markets (including Westpac) were forecasting. That is because a second 0.8 per cent print on its underlying inflation rate would have meant that inflation in the first half of 2010 was running at a 3.2 per cent annualised pace. With economic growth around 3.5 per cent (just above trend) for the year it would not have been possible for the bank to retain its forecasts of 2.75 per cent for underlying inflation in 2010 and 2011. Raising the forecast to 3 per cent (the top of the bank's target zone) would mean that it was forecasting that the low point in the inflation cycle was at the very top of the target zone.

The bank is forecasting that growth in the Australian economy will increase from 3.25 per cent in 2010 (trend) to 3.75 per cent in 2011 and 4 per cent in 2012. Both those growth rates are above trend with the clear implication that inflation will be rising through 2011 and 2012.

With interest rates 'only' around neutral at the moment there would be a clear expectation in the bank that rates will have to rise not fall in 2011.

Of course, central banks get their forecasts wrong along with others, including the market. The key issues from the Reserve Bank's perspective appear to be: whether private sector business investment will recover to fill the gap which is now being created by the slowdown in the government's stimulus package; whether the Australian consumer remains as cautious as we have seen over the last few years; and the outlook for the Chinese economy and Australia's terms of trade.

On the investment front, we expect that while the surprise contraction in business equipment investment in the June quarter (and a likely flat result for total business investment in the period) will raise a few eyebrows, the outlook seems quite up-beat. Our analysis of the well respected ABS CAPEX survey of investment intentions which was released at the same time as the June quarter data indicates that investment in the 2010-2011 fiscal year is expected to increase by 28 per cent in nominal terms – up from the last estimate of 19 per cent.

We don't think that the US economy or its financial markets are going to figure prominently in the official sector's thinking on interest rates.

We think that it is very likely that the RBA will remain on hold for the remainder of 2010. Even if the Q3 inflation print in late October is 'high' we doubt whether it will be high enough for the Reserve Bank to see the need to change its inflation forecast.

An extended period of steady rates is likely to see a much more confident consumer than the one who over the last few years has been battered by fears of job loss followed by eight months of rising rates. In May 2009, we surveyed consumers about their expectations for house prices. Around half the sample expected prices to fall. That was a reliable assessment of how 'fragile' consumers were feeling.

Only 3 months later the Reserve Bank was raising rates, despite ongoing uncertainty in the world economy. While we don't expect to see the consumer moving back into that mode of drawing down equity in their houses to spend at a faster pace than their incomes are growing at, we do expect them to step up their spending to at least match the growth in their incomes.

That is going to see a much more positive consumer spending profile in the second half of 2010. Whereas we estimate that consumer spending grew at a 2.5 per cent pace in the first half of 2010, we expect that to pick up to 3.5 per cent in the second half.

A more encouraging profile for consumers is also likely to encourage business to add to capacity. While mining investment looks certain to grow strongly due to the $43 billion Gorgon project the real issue relates to other sectors of investment. Private sector business surveys; measures of capacity utilisation; capital goods imports; and the investment plans as surveyed by the Bureau of Statistics all point to a recovery in business investment over the course of 2010 and 2011.

Finally, we are left with the outlook for China. It is clear from various statements and reports from the RBA that the Bank is optimistic about the near- and medium- term outlook for China.

Leading indicators and measures of data momentum point to a current slowdown in the Chinese economy. However, we expect that government policy will soon be directed at reasserting China's growth rate. Policies to ease the availability of credit and reboot private and government construction spending are likely to be adopted. Unlike the US, where policy paralysis seems to be forcing an unnecessary fiscal tightening on the economy, Chinese policies are likely to be closely attuned to growth.

For market pricing, which is currently predicting a rate cut with about a 50 per cent probability by year's end, to be franked we will need to see a continuation of highly cautious consumer behaviour; a sharp downturn in business investment; clear evidence of a substantial slowdown in inflation and, most importantly, real doubts about China's near term growth prospects. Further falls in US bond rates and disappointing US economic data might be enough for markets but will not sway an optimistic Reserve Bank.

As a general comment, those who are currently exposed to interest rate risk and are in a position to take advantage of these very low interest rates should be giving serious consideration to taking some risk off the table.

Bill Evans is Westpac chief economist