WEEKEND ECONOMIST: Prepare for tightening

Consumer confidence might be down, but a separate survey on consumers' inflation expectations shows that most people think inflation will remain well outside the RBA's target band. That means an interest rate rise is still on the cards.

This Tuesday’s release of the March RBA Board minutes should shatter the market’s complacency in relation to future tightening prospects. We expect the RBA to reveal a much more explicit tightening bias than was
evident in the statement accompanying the March tightening. This would simply be a repeat of the RBA’s performance in February, when it made no statement about future policy direction when announcing the February
tightening, only to highlight the need for further substantial tightening in the minutes released two weeks later. One of the reasons the RBA has an inflation problem is that it has not appropriately conditioned expectations for future interest rates movements through its public statements for much of the current tightening episode. This has eased the effective stance of monetary policy, by lowering expectations for future rate rises.

The minutes pre-date this week’s release of March consumer confidence data, which has seen many in the market calling an end to the RBA’s tightening cycle. As a rule, it is activity that drives sentiment, not the other way around, although the consumer confidence series does serve as a more timely read on activity than is available from other data and still has some explanatory power for activity that is not picked-up in other releases. Consumer confidence is very volatile, however, and needs to be heavily smoothed. The series enters our models as a four-to-six month moving average. Applying a six-month moving average shows a downturn in consumer confidence that is not unusual by recent standards:


The decline in sentiment sits rather uneasily with the further decline in the unemployment rate in February to new trend lows of 4 per cent, levels last seen in the November quarter 1974. This strongly suggests the decline in sentiment in March has more to do with overwrought reporting of interest rates increases, rather than actual economic conditions.

Almost no attention was paid to that other survey of consumers released this week, which measures their 12-month inflation expectations. The median expectation rose to 4.6 per cent in March from 4.5 per cent in February, the sixth straight reading above 4 per cent. All else being equal, rising inflation expectations reduce the expected real interest rate, demanding further increases in actual nominal interest rates to keep monetary policy on a restrictive footing.

Consumers do remain confident about one thing: the RBA won’t be meeting its inflation target this year. The percentage of respondents expecting inflation to be consistent with the RBA’s target range over the next 12 months fell to 11.8 per cent, the lowest since June 2000. There is only slightly more popular conviction behind the RBA’s inflation target than opposition leader Brendan Nelson. As RBA Governor Stevens noted in a speech to Treasury officers this week, "one of the most important jobs of monetary policy is to condition expectations. To achieve that, people have to believe we will do what is required to control inflation over time." If only Stevens would also walk the talk when it comes to anchoring inflation expectations.

The inflation expectations survey shows that the real risk is not that the RBA tanks confidence and activity with excessive tightening in the near term, but that it validates a structural increase in inflation expectations by letting inflation run above target for too long. The longer the RBA delays the necessary adjustment to real interest rates, the more painful the subsequent disinflation will have to be and the greater the medium-term risk of a monetary policy-induced recession.

The decline in ANZ job ads in February was also seen by some as implying that the economic end is nigh, but given that this was the first monthly decline since November 2006, there is no reason to be pessimistic on the labour market just yet. The labour market is a lagging, not a leading indicator. It will almost certainly take a decisive change in the trend of the unemployment rate to induce a new RBA easing cycle, but that turning point is nowhere near evident in the data.

This week’s January housing finance release confirmed that new lending commitments remain subdued, with re-financing still dominating the headline figures. At the same time, continued growth in the value of housing lending suggests that credit conditions are not overly restrictive. Consumer confidence is an input into our housing finance forecasts and points to continued weakness in both housing finance and building approvals. The supply-side implications of this weakness are further upward pressure on rents, house prices and inflation.


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