This week's developments have, in our view, firmed up the probability of a rate hike by the Reserve Bank on November 2. Of course the board minutes from the October meeting which delivered the surprise "on hold" result will be closely scrutinised, particularly because there was so little detail in the governor's associated statement on the day of the October board meeting.
We noted at the time that the key policy statement in the governor's statement was almost word for word equivalent to the statement following the February meeting, when the Bank last surprised the market with a decision not to move. Recall that it delivered a hike at the next meeting despite the market "giving up" following its disappointment in February.
In October: "If economic conditions evolve as the board currently expects, it is likely that higher interest rates will be required, at some point, to ensure that inflation remains consistent with the medium term target."
In February: "If economic conditions evolve broadly as expected, the board considers that it is likely that monetary policy will, over time, need to be adjusted further in order to ensure that inflation remains consistent with the target over the medium–term."
We assess that the factors which may be prompting the Reserve Bank to contemplate another pause are: the rise in the AUD; concerns about a "cautious" consumer and falling business confidence.
AUD and interest rates
Coverage on the link between the AUD and interest rates is, as in previous periods of strength against the USD, much confused.
Our view is that using the nominal AUD/USD exchange rate overestimates the degree to which the currency might be a constraint on the economy. The Reserve Bank understands that the correct exchange rate concept where aggregate demand is concerned is the real trade weighted index, which measures economy wide shifts in competitiveness. If that index moves broadly in line with its historical sensitivity to the terms of trade, then the exchange rate is doing its job and is not a constraint on policy.
Over the last 12 months the real TWI has increased by around 15 per cent compared to a 22 per cent increase in the terms of trade. Currency adjustments have therefore reduced the stimulatory impact of the terms of trade to a degree, but the combined effect of the two remains net stimulatory and powerfully so.
Going forward we are forecasting that the current level of the terms of trade will remain broadly steady through the next year or so. US QE influenced near term strength in exchange traded commodities will offset a softer fourth quarter contract price for the bulks. However we are also expecting that the nominal TWI will also be broadly steady (with the real TWI a little higher). We see the move in the AUD to $US1.05 through to June next year as being dominated by USD weakness. The nominal TWI is likely to increase by around 2.5 per cent through to June 2011 and then fall around 5 per cent in the second half. That will mean an actual 3 per cent fall in the nominal TWI from October 2010 through to end 2011.
On the other hand we expect a 5 per cent fall in the USD Index through to mid year. Such an estimate includes a reasonable assumption that euro will gain around 7 per cent against the USD; while the Asian currencies, including the RMB, will gain around 2-4 per cent.
In short, currency movements to date, taken together with the terms of trade surge, have actually been net stimulatory to the Australian economy. Looking forward, despite our expectations that the AUD will strengthen further against the USD, in trade weighted terms we expect little movement; consistent with our views around the terms of trade. It is very unlikely that the Reserve Bank would view these currency issues any differently making it unlikely that it would refrain from acting on its strong tightening bias because of the AUD reaching parity with the USD.
Consumer not so cautious
The Westpac-Melbourne Institute Index of Consumer Sentiment increased by 3.3 per cent in October and some details in the report suggest the consumer might be finally shedding some caution.
The level of the index is around 2.5 per cent above the average for 2010; around 15 per cent above the low point in the year (which followed the three consecutive rate hikes in March to May and the uncertainty over the original announcement of the mining tax); and 15 per cent above the long term average for the Index.
This evidence is apparent from an analysis of the components of the index. Expectations for economic conditions over the next 12 months rebounded by 7.6 per cent after a 7.2 per cent drop in September and five year expectations were up by 1.4 per cent.
The two components of the index that cover respondents' assessments of their own finances were actually down. The index measuring opinions on "family finances compared to a year ago" fell by 0.8 per cent while the index tracking expectations for finances over the next 12 months fell by 3.8 per cent. However, this caution about family finances did not affect spending intentions which are gauged by the component question of the index, "Is now a good time to buy major household items?".
Importantly, households were notably keener on buying a major household items in October, probably reflecting strong employment conditions and the rising Australian dollar. This component jumped by 9.9 per cent in October and is now 11.6 per cent above its level a year ago and at the highest level for more than five years, a period that covers the consumer spending boom in 2007. This is in contrast with the overall index which is actually 3.6 per cent below last year's level. These developments in the "time to buy" component of the index point to a strong start to the Christmas selling season and suggest we may start to see some pick up in consumer spending more generally.
Our experience with the "time to buy" index is that it has generally sends reliable signals about overall spending patterns. The high AUD will be encouraging spending and prompting the cautious consumer to loosen the strings a little.
Business conditions also bounce back
The NAB monthly business survey revealed that business conditions improved to 6.7ppts in September, from 4.5ppts in August.
Moreover, forward orders, stocks and capacity utilisation all improved. However, confidence edged a little lower, although that followed a sharp rebound in August.
This is a positive update on the Australian economy and is at odds with the weakness evident in some other private sector business surveys of late.
The NAB conditions index remains above trend. While the AiG PMI – which is more volatile – dipped below 50 (indicating manufacturing contraction) in September.
We judge that the NAB index is providing a more reliable guide to overall conditions in the economy. The divergence between the two surveys (NAB vs AiG PMI) may in part be because the NAB survey is picking up the boost to the overall economy from the strength in mining, while the manufacturing sector is not performing as well.
Bill Evans is Westpac's chief economist.