WEEKEND ECONOMIST: Rates on hold

The Reserve Bank Board next meets next Tuesday. There is little chance the Board will decide to change rates next week. In our note last week we pointed out that the two key factors (apart from an unexpected global meltdown) that will influence the Board from this point will be the unemployment rate and the need to support business lending.
The Bank is unlikely to watch a sharp increase in the unemployment rate (we expect our forecast move from 5.7 per cent to 7.5 per cent will be enough) without action particularly given the relative level of our rates.

Customers often ask for a longer term perspective on rates. Below we set out our thinking for the medium term outlook.The future profile of interest rates will be largely dictated by the timing and the shape of the economic recovery over the next few years.

We expect that growth in the Australian economy will be particularly insipid over the next 18 months. For the second half of 2009 we expect the Australian economy to actually contract at a 1.6 per cent annualised pace and to grow by only 1 per cent in 2010. Thereafter we expect growth can pick up markedly as the massive headwinds from the global financial crisis ease significantly.

For Australia, with considerable excess capacity being accumulated through 2009 and 2010 as the unemployment rate settles around 8 per cent (4 ppts above the lowpoint in early 2008) the economy will be able to react smoothly to a recovery in demand and confidence to more normal levels without pressuring inflation.

However we are suspicious about the current sharp increase in confidence which has many commentators talking about a 'V'-shaped recovery for both Australia and the major economies, the US; Europe and Japan. The clear issues for us are the reliable observations that economies take longer to recover from a recession associated with a financial crisis. That points to the recovery year (2010) being marked by very weak growth although an improvement from the savage contractions of 2009.

Markets are currently priced for central banks taking back a good part of the aggressive rate cuts which they implemented during the financial crisis but we expect that the profile of the recovery will be fragile and central banks will be reluctant to risk 'killing' the recovery before it gains a much more solid foundation than we expect will be likely through 2010. The attitude of central banks is likely to be that mistakes have been made in the past in countries like the US (1930s) and Japan (1990s) in tightening policy too early in the cycle only to see economies fall back into recession – we expect that central banks will view it as better to leave rate hikes as late as possible but then to move swiftly.

For that reason we expect that the Reserve Bank of Australia will keep rates steady through 2010 prior to a rapid move back to 'neutral' in 2011. That is likely to herald the beginning of a 12–18
month cycle of rising rates culminating in rates moving into the contractionary zone (5 per cent – 6.5 per cent) in 2012.

Swap rates have moved too far too quickly in this cycle with current pricing implying a 100–200 bp's increase in the cash rate in 2010. We expect swap rates will ease back over the course of the second half of 2009 as markets become more aware of the "patience" that the Reserve Bank and the US Federal Reserve are likely to exercise in 2010. We expect the unemployment rate to rise by around 2ppt's to 7.5 per cent by the end of 2009. That is likely to be met with a couple of 25 bp rate cuts from the RBA shaking the conviction of swap markets that the RBA will be reversing those moves as soon as early in the following year.

However, through the course of 2010 as the damage from the global financial crisis eases and the national unemployment rate appears to be stabilising, markets will more confidently focus on above trend growth in 2011 and a rapid rate hike response. Note that when the Australian economy finally emerged from the aftermath of the early 1990's recession with growth prospects approaching 5 per cent the swap rate soared to be over 400 bp's above the cash rate as the market envisaged a very sharp increase in the cash rate. This time we are unlikely to expect such a sharp increase in cash rates so we would envisage a more sustainable 300 bp peak excess of the 3 year swap rate over the cash rate. That peak spread is likely to be reached shortly before the RBA begins its tightening cycle.

The tightening cycle which is expected to begin in early 2011 should last 12 – 18 months. The last tightening cycle (first tightening to last tightening) started in May 2002 and ended in March 2008. That cycle was unusually long. The combination of solid growth without an associated rise in inflation enabled policy makers to run relatively easy policy. However it is generally accepted that during that period central banks kept rates low for too long sowing the seeds of the housing and credit excesses that have since been so devastating for the world economy. Prior tightening cycles were much shorter – 9 months (1999/2000) and 5 months (1994).

We are providing forecasts out to December 2013. The tightening cycle is likely to cover 2011 and into 2012 prior to a period of steady rates through the remainder of 2012 and 2013. The year 2013 is likely to be a year when cash rates are held at their peak. That peak will be below the previous peak of 7.25 per cent. High levels of household gearing, which are not forecast to ease significantly in this cycle, are likely to bite hard when mortgage rates rise by at least 400 basis points. That likely growth slowdown should see markets expecting rate cuts by 2014 and swap rates easing below the cash rate by the end of 2013.

Bill Evans is Westpac's Chief Economist.