In last week's note we strongly reconfirmed our view that the RBA would raise rates by 25 basis points on February 2. We argued that the CPI would be largely irrelevant to the decision.
Our view remains that the Bank is planning to move the cash rate back to the "neutral" target level of 4.5 per cent by June at the latest with the first move of 25 basis points coming next week.
While we did not expect the CPI to impact on the February 2 decision it may have some impact on the pace at which the 4.5 per cent is achieved. A plus was a drop in the quarterly core measures. We estimate 0.55 per cent for the trimmed mean and 0.71 per cent for the weighted median compared with 0.77 per cent (trimmed mean) and 0.79 per cent(weighted median) last quarter. However, detailed scrutiny of the components of the CPI are consistent with strong domestic demand conditions. Retailers were able to hold up prices of discretionary items such as clothing and footwear, household goods and recreational goods more successfully than we anticipated. These details will give the RBA no comfort whatsoever and further emphasise the need for moving rates back to neutral.
At the time of writing this note we are very surprised that markets are now priced for only around a 50 per cent probability of a 25 basis point rate hike next week.
For us, the issue is not whether the RBA raises rates by 25 basis points next week but how quickly they move to the "neutral" level of 4.5 per cent, entailing two further rate increases of 25 basis points each. Next week we will see guidance from the Bank on how they currently see that rate profile. There will be the Governor's Statement on Tuesday following the rate decision and the Statement on Monetary Policy on Friday.
The key sentence in the Bank's November Statement on Monetary Policy was: "The cash rate remains at a low level, and a further gradual lessening of monetary stimulus is likely to be required over time if the economy evolves broadly as expected." By next Friday we expect rates will have increased by a further 50 basis points since the November Statement (December and February). We have also seen the December 16 speech by the Deputy Governor which effectively redefined "neutral" as 4.5 per cent.
It is therefore likely that the Bank will soften this sentence by leaving out "low level" but retaining "gradual lessening of monetary stimulus". If this second term is excluded from the commentary then markets are likely to expect rates to remain on hold in March and probably April as well.
We do not expect any significant changes to the Bank's forecasts. The November forecasts for GDP growth in 2010 and 2011 are 3.25 per cent each – we forecast 3.4 per cent; not a sufficient difference to justify the Bank changing its forecast.
For underlying inflation, the Bank is forecasting 2.25 per cent in 2010 and 2.5 per cent in 2011. We expect underlying inflation of 2.5 per cent in 2010 and 3 per cent in 2011. For 2009, the Bank had forecast 3.25 per cent for underlying inflation while the average of the Bank's two underlying measures has printed at 3.4 per cent.
Underlying inflation fell from 4.4 per cent in 2008 to 3.4 per cent in 2009. That was in the aftermath of domestic demand growth falling from 6.5 per cent in 2007 to 2.9 per cent in 2008. We expect that domestic demand growth fell from 2.9 per cent in 2008 to 1.4 per cent in 2009. That supports a forecast of a further fall in the underlying inflation rate in 2010. However we think it is a real stretch to expect a sharper fall in 2010 than we saw in 2009. That makes an argument for the Bank to raise its underlying forecast to 2.5 per cent in 2010. Further, we struggle to see the justification for the Bank's forecast of only a mild acceleration in inflation in 2011 – an increase of just 0.25 per cent to 2.5 per cent.
Recall that these inflation forecasts are based on appropriate policy. That leaves the Bank flexibility to maintain its 2.5 per cent forecast for 2011. We expect them to do just that – even though we see the figure as being unrealistic. As for the 2010 forecast, given that policy acts with a lag and the higher than expected starting point, we anticipate that the RBA will lift that number from 2.25 per cent to 2.5 per cent.
History is fairly supportive of our view that the Bank will move fairly quickly to deliver the final 50 basis points to return to neutral.
Consider the last two tightening cycles. After moving to within 50 basis points of neutral (assuming it assessed neutral as 5.5 per cent) the RBA took only three months to get from 5.0 per cent to 5.5 per cent in 1999–2000 and 15 months in 2003–2005. However in the latter episode the move to 5.25 per cent occurred in the month following the rate hike.
The delay in moving more quickly in 2004 provides interesting evidence on what economic developments might delay the Bank's move to neutral. Recall that the response to the November and December 2003 tightenings was a 5 per cent tumble in the Westpac Consumer Sentiment Index and a near 20 per cent fall in housing finance approvals. In both episodes Consumer Sentiment was around 20 per cent lower than its current prints.
Is Neutral Really as Low as 4.5 per cent?
In the speech by the Deputy Governor when he redefines "neutral" as probably 1 per cent lower than previously assessed his analysis relies on "other interest rates in the economy having risen by at least 100 basis points relative to the cash rate over the past couple of years". However he is presumably referring to average private sector rates because elsewhere in the speech there is reference to, "the margin on variable housing loans is much the same today as it was at the start of the crisis...margins on business loans are now substantially higher than they were immediately before the crisis."
If therefore we were to think of a neutral cash rate for housing and one for business it is reasonable to conclude that "housing neutral" might be much closer to 5.5 per cent and "business neutral" might be around 3.5 per cent.
Current credit trends lends support to this notion - with business credit contracting by 7 per cent through 2009, in contrast to an 8 per cent rise in housing credit. While there are a number of factors at play, the two neutral rates presumably explain some of this large gap.
Looking forward, it is therefore likely that the housing/household sector will be more resilient to the next stage of rate hikes than would be expected if rates were almost at "neutral". Evidence of that behaviour will only encourage our view that the moves to 4.5 per cent will be fairly rapid.
Bill Evans is chief economist at Westpac.