The minutes show a very significant increase in the Bank's level of urgency with regard to monetary policy.
It has been our view that the best policy approach is to delay the next move in the tightening cycle until next February. That would give the cautious consumer some breathing space before the next onslaught of rate hikes; allow more time for the troubling weakness in credit growth to recover and to provide more time to evaluate the current "uncertain" global economic environment.
However, our reading of the minutes indicated that the Bank is set to move on October 5.
The reasons why we interpret the minutes in that way are the following:
1. The concerns with the inflationary impact of the mining boom have been heightened markedly. "Members observed that previous investment booms and increases in the terms of trade had posed significant challenges for economic policy, and that high levels of resource utilisation were likely to put pressure on inflation." Previous minutes (and statements by the Governor) have not specifically highlighted this risk with such strong prose.
Our concern here is that the Bank is approaching the inflation risks from the mining boom from the perspective of a huge boost to incomes. However the transmission from incomes to spending is not at all clear. The income accruing to the government is likely to be saved to assist with the reduction in sovereign debt levels. The net income accruing to the mining companies is either paid out in dividends (mainly to foreigners); held in retained earnings or reinvested with the investment decision being a global issue.
Direct mining employment workers represents a minuscule part of the workforce (maybe 1 per cent) although of course services and the manufacturing sector benefit from supplying demand from mining projects. Rigidities in the Australian labour market prevent the markets from clearing with the result that supply constraints are likely to slow the development of the $100 billion – $150 billion of projects which are being planned.
The Reserve Bank is clearly much more convinced about the inflation risks and is prepared to act before some other issues, particularly associated with the attitudes of consumers, are clear.
2. The warning that rate rises are on the way was explicit "it was likely that higher interest rates would be required, at some point". The Board indicates that such policy reaction would be required under its "central scenario". The central scenario includes "quite a subdued outlook for the main G7 economies and around trend growth in Asia". This clearly emphasises how the Bank's global outlook is being driven by its assessment of Asia rather than the need for a more vibrant G7.
3. We should not give too much weight to the minutes describing other risks. The September 2009 Board minutes were used to signal an imminent policy tightening with the first rate hike in the 2009/2010 sequence of six hikes beginning in October. At that time some balance was used in the statement language "some uncertainty remains about the outlook both abroad and at home." The latest minutes also qualify the strong preceding language with "members noted the risks to this outlook". But it is our assessment that this qualification is, as with previous statements, not sufficient to neutralise the clear impression that a move is imminent.
4. A key theme in previous minutes (which in our view represents a substantial ongoing headwind for the economy) relates to the cautious consumer. In the August minutes, the Bank referred to "households generally remained cautious in their spending". Now, it notes that "the cautious approach to spending seen over recent times could be starting to wane".
5. On the cash rate itself, the August minutes referred to "decided to leave it unchanged for the time being, pending further information". The September minutes could be interpreted that no further information is required given that "pending further information" has been dropped. When the Bank was signalling the beginning of the rate cut cycle in the August 2008 minutes the policy rate was described as "appropriate for the time being". When it was signalling the beginning of the rate hike cycle that kicked off in October 2009, the September minutes stated that the policy rate would be "unchanged for the time being, pending further information". There is no consistency here, but it is not unreasonable to conclude that the decision to tighten is stronger than it appeared to be in September a year ago.
This likely decision to move before the September quarter CPI makes a lot of sense from the Bank's perspective. We know that the Bank regretted linking rate hike decisions to the CPI in the 2006/2007 period. A sequence of lower than expected quarterly CPIs delayed the necessary tightening by nine months. That partly laid the foundation for underlying inflation reaching 4.8 per cent in 2008. A surprisingly low Q3 CPI might sway the Board from the tightening which it clearly believes is now necessary.
The inflation blow out in 2008 which coincided with the end of Mining Boom Mark 1 may also have unnerved the RBA from the perspective of inflation risks. However a major difference is that in Mining Boom Mark 1 the government was a spender rather than the saver we anticipate for Mining Boom Mark 2. Furthermore the attitude of the consumer in that period was much more upbeat than we see today.
Our previous view (which we held despite the market giving a 100 per cent probability to a rate cut as recently as a month ago) was that a total of 75 basis points of tightenings could be expected through 2011 beginning in February. It now seems likely that the Bank will choose to follow the October move with another one in November as long as there is no major downside surprise with the Q3 CPI or a substantial sentiment shift. (Recall that the general expectation was for a second move in April 2005 to follow the March rate hike of 25 basis points. The Westpac–MI consumer sentiment index fell by 15.5 per cent in March and the Bank delayed any further move until May 2006.)
We expect that the underlying inflation rate for the September quarter will be 0.7/0.8 per cent and that will be sufficiently high to allow a follow-up move, if the Bank so desires.
Markets are currently pricing in a probability of around 50 per cent for an October move and a 100 per cent probability of one full move by November.
Apart from the impact on confidence that a rate hike in October could bring there is also a much discussed risk of banks raising their mortgage rates by more than the RBA's 25 basis point move. Any decision by banks to take that route would eliminate a follow up move in November by the RBA – the banks would be doing part of the RBA's job for it.
Reports indicate that banks' margins have been contracting. The dominant explanation for the contraction in margins was initially the sharp increase in funding costs for wholesale funding both domestically and, in particular, offshore.
However, recently we have seen a sharp increase in the margin between the bank bill rate and the banks' retail deposit rates (Figure 1). As banks have scrambled to reduce their exposure to expensive and sometimes hostile global capital markets (see Figure 2 for funding margins) their more intense reliance on retail deposits has seen a significant increase in funding costs – much to the benefit of household depositors.
Rising cash rates may allow the banks to maintain an attractive absolute level of deposit rates while managing some reduction in the funding margin. In time that may take some pressure off mortgage rates. A switch in banks' attempts to protect margins from managing asset margins to managing liability margins has obvious implications for monetary policy.
However, our overall assessment is that rates will still only be around 5.25 per cent (from the current 4.5 per cent) by the end of 2011. We think that three more rate hikes, when combined with a significant fiscal tightening and constrained credit, will be sufficient to allay the Bank's current inflation fears.
The developments over the last week have been unambiguously positive for the Australian dollar with an increase of US2¢ at one stage during the week. However there has been minimal movement against the Euro indicating that the markets' assessment of Fed's approach to quantitative easing has dominated the movement in Australian dollar against the greenback.
With our view that growth in the US economy will settle around 1 per cent in the second half of 2010 and around 1.5 per cent in 2011 the case for quantitative easing by the Fed will be strong. We expect it to be calibrated as the growth picture unfolds with the Fed's balance sheet expanding by around $US800 billion through to the curtailment of the policy in the second half of 2011. The timing of that event is likely to signal renewed interest in the US dollar.
That policy will be US dollar negative and an Australian dollar positive although steady Aussie dollar interest rates (only one hike is now expected for 2011) and ongoing global uncertainty (partly due to the sluggishness of the US economy) are likely to limit the gains in the Australian dollar. We are now noticing banks and forecasters we have never even heard of getting on the "parity bandwagon" for Australia. That may well be the right call but at this stage we remain constructive on the Australian dollar without expecting a sustained move above parity through 2010 and 2011.