He noted: "If we were prepared to cut rates rapidly, to a very low level, in response to a threat but were then too timid to lessen that stimulus in a timely way when the threat had passed, we would have a bias in our monetary policy framework.”
We also note that, quite unusually for a central banker, he was prepared to question the veracity of the official inflation forecasts: "In fact, in late 2009, we are still to see whether inflation will be consistently back to target over a period of time. We think it will be, but, as yet, that remains a forecast.”
We now expect the bank to tighten by 50 basis points on November 3, to be followed by a further 25 basis points on December 1. That will restore the overnight cash rate to 4 per cent. Another couple of 25 basis point increases can be expected in the first half of 2010, with the cash rate to reach 4.5 per cent by around May. With rates back to more normal levels and lead indicators such as consumer and business confidence and housing finance approvals (driven by both weakening demand and constrained supply) softening we would anticipate a pause for the remainder of 2010.
Last week we discussed that due to our upgrade of our labour market outlook with a lower peak in the unemployment rate of 6.5 per cent (revised from 7 per cent) there were upside risks to our estimated peak rate level of 4 per cent in 2010. With the more rapid rate increases now expected in 2009 that peak of 4.5 per cent now seems to be the most likely scenario.
Note however, that the forecast peak in 2010 is still well below current market expectations of 5.25 per cent. This more aggressive, near-term profile for the RBA has clear implications for the Australian dollar. Our research clearly points to the main driver of recent Australian dollar strength being interest rate differentials rather than commodities. Our near term forecasts point to a larger widening of the Australian dollar/US dollar differential than is currently priced into markets. While commodity prices have been stable over the last three months the Australian dollar/US dollar has surged by 15 per cent and that would appear to be mainly explained by the increasing attraction of Australian dollar rates.
Our revised rate view points to continuing momentum in the Australian dollar, through to year’s end with a revised target of $US0.98 by end December. We would see that level holding through the March quarter before a substantial correction through to June as the market reacts to the expected pause by the RBA and global equity markets retrace as US markets realise that the revenue expectations embedded in equity prices cannot be delivered by the ailing US economy (see further discussion below).
Data risks to the 50 basis points rate hike in November and the 25 basis points in December.
It appears to us that the RBA currently expects to tighten by 50 basis points in November, although near term data developments will always have a significant impact on that decision. The most important data release before the November meeting will be the print of the September quarter CPI on October 28. Our preliminary estimate for core inflation is a read of 0.8 per cent. While that will bring annual core inflation down to 3.5 per cent from 3.9 per cent, the quarterly profile of the underlying measures (0.8 per cent last quarter as well) points to the RBA’s current forecast of 3.25 per cent annual core inflation in 2009 being highly unlikely to be achieved. With 0.7 per cent dropping off from the December quarter last year a core print of 0.4 per cent would be required in the December quarter in 2009 to achieve the 2009 target.
Despite the higher Australian dollar, that sharp reduction in the core measure seems extremely unlikely .The governor’s concerns about achieving of the official forecasts for inflation would appear to be well founded and support the more aggressive move in November.
Last week we discussed the possibility of a substantial statistical correction in the employment numbers, which will print on November 12. We currently estimate a 30,000 fall pushing the unemployment rate back to 6 per cent. That style of number would deter the Bank from a follow up 50 basis points in December but not 25 basis points, given the governor’s clear feeling of urgency and the likely supportive nature of other data releases before the December meeting (including retail sales and business investment).
In that context, it is likely to assess the September/October employment numbers together to conclude, reasonably, that the overall employment trend is steadily improving.
Our rate peak in 2010 is well below market expectations
From May 2010 we expect a break in the RBA’s rate hikes with a pause in the second half. Issues will be:
1. After the cash rate reaches 4.5 per cent the standard variable mortgage rate will be around 7.3 per cent. In the previous rate hike cycle we found that once the SVMR exceeded 7 per cent households were extremely sensitive to rate hikes. The average fall in the Westpac Consumer Sentiment Index was 8.5 per cent following each of the subsequent rate hikes. That sensitivity caused the RBA to extend the rate hike cycle over a further three years.
2. Previous housing recoveries have been largely driven by demand and the supply of credit has adjusted to accommodate demand. In this recovery the supply of credit will be a significant constraint. Australia still has a substantial foreign debt challenge (around 53 per cent of GDP). That is broadly funded by the Australian banks who have not seen any marked improvement in funding costs since the introduction of government guarantees. Banks are still funding term offshore debt at 180–200 basis points (after guarantee costs or non-guaranteed) above bank bill compared to 30 basis points prior to the crisis. At the margin that funding cost will act as a constraint to the availability of funding for both mortgages and SME loans. With limited prospects for improvements in global markets these supply constraints will impact the availability of credit in 2010.
3. Limits on the supply of credit are likely to also constrain the pace of recovery in the US, Europe and UK. While household demand may respond to, say, falling house prices and rising affordability, credit supply constraints will contain the pace of recovery. Political pressures are likely to limit any substantially further enhanced role for government. Indeed, governments’ roles become counterproductive as they crowd out the household and SME sectors with their excessive demands for their own funding.
4. Equity markets are likely to experience a significant reversal following the inability of the US economy to justify earnings expectations. Growth currencies like the Australian dollar are likely to experience a setback in that environment.
5. Debt servicing ratios for Australia’s household sector will rise quickly. Rising debt to income ratios and higher rates will see household debt servicing ratios reach 2007 levels in the second half of 2010. We expect the household debt servicing ratio to reach 14.22 per cent by end 2010. That compares with an average of 13.7 per cent in 2007 and 14.5 per cent in 2008. Despite average interest rates being 1.5 percentage points higher in 2007 compared to 2010 the ratios are comparable due to the higher household debt/income ratios in 2010. The ratio will have risen from 11.09 per cent in June 09 (3.1 percentage points) with 1.1 percentage points due to higher debt/income ratio and 2 percentage points due to higher interest rates.
Implications for the Australian dollar in 2010: USD 0.98 in December 2009; USD 0.92 in June 2010; USD 0.95 in December 2010.
Our global view points to commodity prices moving largely sideways in 2010. We also expect that market expectations on Australian rates will be disappointed in 2010. Once the RBA pauses markets are likely to focus on potential rate hikes by the FED. We see that as more of a 2010 H2 event than H1 due to our negative view on the sustainability of the US "recovery” in 2010 H1.
This disappointment in the pace of the US and European recoveries, partly associated with the credit supply issues, is likely to see markets downgrading their global growth views in 2010 H1.
We have long argued for a retracement in the Australian dollar in the middle quarters of 2010 largely reflecting these factors. Certainly we would still expect that 5-10 big figure correction around that time but it now appears that it will be from a much higher base.
Prospects for a more durable global recovery and a resumption of RBA tightenings should restore the the Australian dollar to global favour in 2011 despite Federal Reserve tightenings attracting some market attention. While interest rate differentials have and will dominate the Australian dollar sentiment for 2009 H2 and 2010, a resurgence in commodity prices as the global recovery attains a broader base should see the Australian dollar recovering some of the ground it is likely to have lost in those middle quarters of 2010. While we are predicting solid weakness during 2010 we cannot argue that the the Australian dollar is fundamentally overvalued given the secular rise in Australia’s terms of trade and our view that commodity prices will enter a renewed up swing in 2011.
Bill Evans is chief economist at Westpac.