RBA Governor Glenn Stevens has the market expecting a rate rise in December, but the RBA board is more likely to wait until the second half of 2010 before lifting again.

The market is now priced for around 200 basis points of rate hikes through 2010 starting with a first move in December this year. Markets were given considerable support for their view from a speech which was delivered by the RBA Governor on July 28. In that speech the common themes of previous RBA speeches – output gaps; rising unemployment; global recession and contracting business investment – were replaced with the need for central banks to contain inflationary expectations; risks of housing bubbles; China optimism; consumer confidence at or above long term averages.

Adding further to the bearish rate assessment was the Governor's performance in the Q & A session. He was given the opportunity to question the value of sentiment indexes but chose to endorse them when significant moves print. He allowed himself latitude to not need to wait until the unemployment rate starts to fall before he can raise rates (previous beginnings to tightening cycles – August 1994; November 1999; May 2002 – all occurred after the unemployment
rate had peaked – August 1993; April 1997; October 2001 respectively).

My question was: "Rates bottomed out at 4.75 per cent following the last global recession (1993) and now at 3 per cent following the current global recession. Are rates necessarily much lower this time since 'neutral' will be significantly lower because household debt to income ratios are now three times higher today than they were in 1993?" He acknowledged that neutral may have changed; this was a useful concept but not observable and did shift around; and was also affected by changes in the relationship between the target rate and lending rates.

Markets interpreted the speech as indicating that the Governor thinks he is closer to raising rates than he thought he had been in previous speeches. That is a reasonable interpretation of the speech but I do not believe it is signalling an imminent tightening and as such data/circumstances can change which could temper the Governor's current position.

The first development that is required by markets will be in the Governor's Statement next week. That Statement will follow the RBA Board meeting on August 4 when the decision to hold rates steady should be the result. In previous Statements there has been a clause, "scope for further easing of monetary policy". That has been almost mandatory since the Bank has been forecasting that inflation will fall to 1.5 per cent in 2011 – a central bank that is forecasting that inflation will fall below the bottom of the target band should see scope to ease.

However on August 7 we will see the Bank's next Statement on Monetary Policy in which it will have the opportunity to adjust its forecasts. Current forecasts of most interest will be growth in 2009 and 2010 and inflation in 2011. The Bank currently has -1 per cent in 2009 and 2 per cent in 2010 for growth, with inflation at 1.5 per cent in 2011. We would expect the forecasts to be revised to be very close to our own growth forecasts of 0.6 per cent in 2009 and 3 per cent in 2010.

Because growth is still below trend we have only slightly revised up our inflation forecast in 2011 from 2 per cent to 2.3 per cent and kept the 2010 forecast at 2 per cent. The Bank is very likely to revise up its 2011 inflation forecast to 2.25 per cent eliminating the need to maintain the easing bias. That upward revision of the forecast will probably have been made internally before the Board meeting – the new inflation/growth forecast should be part of the Staff's advice to the Board and therefore be factored into the Governor's Statement.

Those revisions to forecasts will probably placate markets although we believe that growth and inflation forecasts would need to be higher still to justify current market pricing. If the Bank does adopt a much higher growth and inflation forecast than we currently expect then the probability of earlier rate hikes would increase.

In last week's Weekend Economist we discussed our revisions to growth but did not bring forward our timing of the first rate hike from our long held view that it would be delayed to early 2011. The thinking was that the Bank would be anxious to hold rates steady for as long as possible to ensure a sustainable recovery. Even our higher revised forecasts still have growth below trend in 2010 prior to trend growth in 2011.

However our reading of the RBA Governor this week clearly depicts an official who will have little patience in waiting once the appropriate conditions have been achieved. That points to some modest 'early' hikes of two 25 basis points in the second half of 2010. We do not expect that the unemployment rate will have confirmed a peak by then but do expect that employment growth will return to positive territory by the December quarter next year. In the first half of 2010 we expect that employment will still be contracting or stagnant at best. In that environment it seems extremely unlikely that the RBA will be tightening.

We are certainly not convinced by the argument of 'taking back' around 100 basis points of the easing since the last two easings in February and April were 'emergency' easings and the need for them has not eventuated. The world economy is still a very dangerous place. The Australian economy will still hardly grow in 2009. The real 'emergency' easing was planned to coincide with the sharp deterioration in the unemployment rate which was expected to unfold in the second half of 2009. That has not happened and is unlikely to happen so there has been no need for an 'emergency' easing and therefore no need to unwind it.

The most convincing evidence of the economic recovery at this stage is the 30 per cent increase in the value of new finance approvals. However, 75 per cent of that increase has been due to First Home Buyers and while our survey work does point to the recovery broadening it would be prudent for the Bank to assess the sustainability of the housing recovery by waiting to assess the impact of the inevitable wind down of the FHB's when the increased grant is phased out by year's end.

History tells us what a sequence of rate hikes can do to a housing market where debt levels are getting stretched. Recall the impact on the housing market of the consecutive 25 basis points hikes in November and December 2003. Prices fell in Sydney; new lending fell 20 per cent nationally; and the next rate hike was not required until March 2005. The unemployment rate was only 5.8 per cent; Consumer Sentiment Index was 114; housing credit growth was running at 20 per cent and global growth was 3.6 per cent. That compares with our current estimates by year's end of 7.5 per cent in unemployment; 90–100 for the CSI; housing credit growth of 7 per cent and global growth at -1.3 per cent.

The current cash rate (3 per cent) is not necessarily that far from 'neutral'. Household debt/income ratio now stands at around 170 per cent compared to 60 per cent in 1993 when rates last bottomed out following a global recession. At that time the cash rate was 4.75 per cent compared to the current 3 per cent. Of course the Bank waited until the unemployment rate was falling; housing credit growth had exceeded 20 per cent; and GDP growth prospects were 4 per cent plus. The impact on household disposable incomes of a rate hike will be three times greater with the higher debt/income ratio.

Just as the 425 basis point rate cut had a much more stimulatory effect on incomes so the reversal would be just as significant. The previous peak in rates of 7.25 per cent seems very unlikely to be exceeded in this upcycle – even the 6.25 per cent rate peak in 2000 might be too high.

Even if the market does not understand this we hope that the RBA appreciates the potency of their policy instrument.

Bill Evans is chief economist at Westpac.


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