For the second consecutive month, the RBA has surprised the market and ourselves with its policy decision, raising the cash rate 25bps to 4.75 per cent. In last month’s report we were adamant that despite no move in October the bank was set to move in November. That was until we saw the minutes associated with the October board meeting. These painted a much more dovish picture for the Australian economy than had been the case in the September minutes. The October minutes questioned the status of the investment boom; qualified the strength of the labour market; and emphasised the cautious consumer. As we fundamentally believed that rates should be on hold until at least February due to the fragility of the consumer; housing and (non mining) business confidence we were eager to interpret the bank’s more measured tone as a sign that they were prepared to be patient – a policy with which we concurred. The concern was that this shift was not forward looking, but was designed to justify a surprise decision not to raise rates in October. Our concerns were justified with the dovish tone being dropped in the November post-meeting statement from the governor despite no truly significant new information.
All the emphasis in the governor’s statement is back on the inflation risks associated with the "large expansionary shock from the high terms of trade”. While the impact on certain industries and regions of high interest rates and a higher currency is noted, it has not been a sufficiently strong argument to wait for further information, despite low current inflation, particularly on the investment outlook. I do not believe that the bank gives enough consideration to the transmission mechanism from the booming terms of trade to domestic demand and inflation pressures.
Our concern is that while the surge in mining investment is undoubted, other sectors of the economy which are domestically focussed – wholesale, retail, transport, communication, housing, non-mining related construction – will all be impacted by prospects for domestic spending, which particularly in the case of the consumer will be further slowed by this unexpected rate hike.
There is good reason to expect that the bank is not contemplating another rate hike in December. The terminology normally used to put readers on notice about that, such as "for the time being” and "pending further information”, is not used in the statement, with the final sentence noting "the balance of risks had shifted to the point where an early, modest tightening of monetary policy was prudent”.
Mindful of the unpredictability of current policy, we must be very careful in deriving too much from those words. Over the next month, there will be an avalanche of information including third-quarter GDP, business investment intentions, wages, retail sales (a weak read on the day after the rate hike with another read before the next RBA board meeting), building approvals (note that approvals fell 6.6 per cent in September, which became known the day after the rate hike announcement), employment, credit and private sector house price measures. However, strong momentum in these numbers, which we are inclined to doubt anyway, would tell us little about the impact of this surprise decision. We expect that the bank will also see it that way and avoid another rate hike in December. Of most interest, since it will capture the impact of this surprise decision, will be Westpac-MI Consumer Sentiment. We expect there will be a sizeable negative response which, despite the bank’s obvious intentions to "make room for investment”, will on its own deter it from a follow up December move.
The tone from the statement means that eventually, more rate hikes can be expected. Our view is that another 50bps on the mortgage rate (in addition to the 25bps from the November decision) will be sufficient to satisfy the bank’s fear of an inflation outburst. Following the rate hike, the CBA raised its variable mortgage rate by 45bps. If that was to be followed with an across the board increase in mortgage rates materially beyond the 25bp RBA move, then we would only expect one more 25bp move from the RBA in this tightening cycle. That move would then be delayed until the June quarter of next year.
We expect growth to be slowing through the second half of 2011 – rates will be too high; fiscal policy will be tightening; and the Australian dollar will be comfortably above parity. The mining boom will be hampered by a shortage of skilled labour although the inflation spill over to wages from this very specific excess demand will be limited. A long period of steady rates will be necessary. The next, and final, round of rate hikes will need to wait until well into 2012.
The November statement on monetary policy has given some confidence about rate view.
In its November statement on monetary policy, the Reserve Bank has slightly changed its growth and inflation forecasts: It has lowered the forecast for underlying inflation in 2010 and for the year ending June 2011 from 2.75 per cent to 2.5 per cent. However, it has retained its forecast that inflation in 2011 will reach 2¾ per cent and 3 per cent in 2012.
It has retained its forecast for growth in non-farm GDP in 2010 at 3.25 per cent, but has lowered the forecast for growth to June 2011 from 3.5 per cent to 3.25 per cent. Growth for the full year 2011 has been retained at 3.75 per cent and 4 per cent for 2012.
The implied half yearly inflation profile has underlying inflation for the first and second halves of 2010, and the first half of 2011 remaining around the 1.2-1.3 per cent pace. It is then assumed to lift to 1.45 per cent in the second half of 2011, drop back to 1.3 per cent in the first half of 2012, and then surge to 1.7 per cent in the second half of 2012. This indicates the assumption that inflation pressures will be modest until the second half of 2012.
The half yearly growth profile indicates that growth in the second half of 2010 will slow to 1.15 per cent from 2.1 per cent in the first half. It is then expected to pick up to 2.1 per cent in the first half of 2011, but then slow to 1.65 per cent in the second half of 2011. Growth of around 2 per cent is expected in each of the halves in 2012, and the first half of 2013.
It is surprising that the bank expects such a slowdown in GDP growth in the second half of 2010, and another slowdown in the second half of 2011. That also puts some doubt on the assessment that inflation pressures will be building quickly in the second half of 2012, given the reasonable rule of thumb that there is a one year lag between economic growth and inflation.
On face value, it would appear that the growth slowdown the bank is expecting in the second half of 2010 will put little pressure on interest rates. We expect a higher growth outcome than the bank is forecasting although not high enough to prompt the need for an immediate rate response. The growth pick-up in the first half of 2011, which the bank is expecting, represents a greater challenge.
We would expect that convincing evidence of this pick-up will be required, and not really available, until the second quarter of 2011. The slowdown which the bank expects in the second half of 2011 is also likely to take pressure off interest rates and casts some doubt on the bank's prior that inflationary pressures will be taking off in the second half of 2012.
Overall, this configuration of forecasts lends some support to our view that the next rate hike can be delayed until the second quarter of 2011. Based on the bank's forecasts, it seems unlikely that it is expecting sufficient growth of inflationary momentum to appear over the next six months to warrant an earlier rate hike.
The explanation of the decision to raise rates is heavily driven by "the economy is experiencing a large expansionary shock from the high terms of trade at a time when there are relatively modest amounts of spare capacity". We are pleased that there is some attempt in this commentary to consider some contrary arguments. It has been our view that cautious households and firms are likely to save a much greater share of the boost to national income from the terms of trade than seems to be the bank's prior. It will also be the case that governments will be focussed on returning the budget to surplus, and similarly saving the benefits from the terms of trade boost. We see that dynamic as significantly lowering the inflation risks that the bank obviously fears.
It is also interesting that there is much more attention given to the exchange rate in this discussion than we have seen previously.
Certainly we understand that a rise in the exchange rate which is offsetting the increase in the terms of trade can be expected. However, as the bank points out, other factors are now affecting the exchange rate. These include Australia's position as one of the few liquid currencies where the central bank is tightening policy, in contrast with the easing of policy which is occurring elsewhere. We are also comforted that the bank recognises risks associated with the delivery of the mining investment projects on time. Slippages associated with lack of skilled labour and uncertainties around commodity prices represent significant risks to the growth outlook.
The bank's forecasts do not signal to us the necessity to raise rates again before the second quarter of 2011. Recall that market pricing is along those lines, and the forecasts are based on a steady exchange rate and market pricing for interest rates.
We are still not convinced that the November rate hike was necessary, and remain concerned that there seems to be a desire to constrain firms and households in order to release sufficient capacity to service the mining boom.
We expect that the data over the next few months will confirm the bank's down-beat view on the near term, and keep rates firmly on hold.
Bill Evans is Westpac's chief economist.