Instead, the Governor’s Statement concluded with, "The current mildly restrictive stance of monetary policy remained appropriate”. This is the same language which was used following the meeting in May and implied to readers that no change was imminent. Adopting the much more hawkish language only three days later in the detailed SOMP led us to the reasonable conclusion that the Bank had adopted a strong tightening bias. With the June Statement no longer using the hawkish language we can only conclude that the strong tightening bias has been taken off the table.
The strange thing is that we were very surprised when the Bank suddenly adopted the hawkish tone on May 6 since we expected that the case for a rate hike had not really been made. We assessed that such a move would do considerable damage to the economy and a long period of healing would be required Another rate hike would not occur until the June quarter 2012. We expect that the Bank itself,in suddenly adopting such strident language was anticipating a series of moves with rates expected to rise by 75–100 basis points by mid next year.
The question is what was it that made the Bank suddenly adopt such a hawkish stance and what made it change its mind just as suddenly. As usual the Inflation Report is the likely explanation for the first sudden change. In the absence of another Inflation Report the reason for suddenly dropping the stance just as suddenly is not at all clear. The sharper than expected 1.2 per cent contraction in the economy in the March quarter is justification, as we anticipated, to skip June but not a reason to drop the bias altogether. Commentary in the Governor’s Statement gave no real clue with a mild but not convincing allusion to risk in Europe and weaker investment plans outside mining.
There are a number of interpretations – the bias has not really been dropped and the communication is intentionally imprecise; alternatively, the bias should never have been adopted in the first place and the Governor/Board had second thoughts. Some argue that the business members of the Board did not support the bias because it first appeared in the SOMP which is written by the staff and not the responsibility of the board but it was repeated in the minutes of the May board meeting so it must have been supported by the entire Board.
We remain perplexed but suspect that a bias still exists even if it is not as strong as in May. In that case, policy will be extremely sensitive to those data series which can spark a rate hike – inflation and the unemployment rate. Evidence that inflationary pressures are strong from the Inflation Report which prints on July 28 will still probably be enough to spark a hike at the August meeting but the print will need to be 0.8 per cent or higher on the underlying rate. It is too early for us to be confident about our CPI forecast but at this stage would not expect a print as high as 0.8 per cent.
Implied in the Bank's current forecast is that underlying inflation will print 0.65 per cent in the June quarter. A print of 0.8 per cent would be a clear message that inflation pressures are building and, following the 0.9 per cent print in the March quarter, provide a strong case for an immediate hike. Anything short of the 0.8 per cent would make it difficult for the Bank given that it had abandoned its official tightening bias.
That does not mean that we should entirely abandon our view that there is one rate hike coming in 2011. Given that the strong tightening bias was adopted as a result of one "bad" inflation print and the staff went out of their way to forecast that the inflation target was likely to be missed in 2012 there will remain heightened sensitivity to inflation prints in 2011. The balance of risks, at this stage, still favours a hike in the second half although we expect that November is more likely than August.
Alternatively, a fall in the unemployment rate to 4.7 per cent would likely be enough to justify a hike. The May employment report printed an increase in the unemployment rate from 4.86 per cent to 4.93 per cent. After creating 200k jobs in the second half of 2010 only 30k have been created in the first half of 2011. Demand growth implies jobs increases of 100k in each half so the weak profile in 2011 could represent a correction to the over hoarding of labour which occurred in 2010. That implies a "soft patch" and growth can be restored to that 100k pace in the second half of 2011 keeping the unemployment rate in the 4.8–5 per cent range – but not really making the case for a rate hike in the absence of inflation pressures. If we are wrong about the "soft patch" and recent developments in the labour market are actually pointing to a sustained downturn then rates will be firmly on hold with the next move being down. Recall that the Bank's whole model is based around labour shortages pressuring wages and inflation. Rising unemployment eases labour shortages; lowers the demand outlook; and eventually requires a policy response.
In summary, there are unusually large risks to the rate outlook now that the RBA has done such a rapid about face. However, such is the Bank's sensitivity to inflation prints, with the memory of the spectacular overshoot in Mining Boom 1 still fresh, it is prudent that our base case remains one hike in 2011. Before and during this period, when the Bank had its fleeting but very strong tightening bias, we have consistently argued that any rate hike is likely to be a "one off” with a follow up move being delayed by 9–12 months.
Our forecasts for final demand growth in 2012 are considerably weaker than the Reserve Bank or Treasury but still imply employment growth of around 2 per cent. That is enough to maintain the unemployment rate around that 5 per cent level over the course of the year. After a long period of steady rates and solid income growth, with the unemployment rate hovering around the NAIRU, inflation pressures are likely to build again through 2012 allowing the Bank to push rates higher by the September quarter.
Bill Evans is Westpac's chief economist.