WEEKEND ECONOMIST: Sooner than expected

The market is pricing in another rate rise in July, but strong employment data and looming inflation risks could force the RBA to move sooner than that.

The Reserve Bank decided to raise the cash rate by 25 basis points to 4.00 per cent. This decision had been expected by Westpac since the surprise pause following the last meeting on February 2. Over the month market probabilities of a rate hike ranged between 30 per cent and the 60 per cent which we assess prevailed at the time of the announcement. The Governor confirmed that the process of moving rates back to average levels will continue and the decision was described as "a further step in that process". We have always assessed this "average" as requiring a cash rate of 4.50 per cent, so, accordingly, we are maintaining our forecast that the next move will be 25 basis points in May, with a final 25 basis points move around July/August prior to an extended pause into 2011.
We note that whereas some months ago markets were pricing in a cash rate of 5.5 per cent by year's end that has now been scaled right back to 4.75 per cent with only one rate hike of 25 basis points priced in by July.

The details of the Governor's Statement show that firstly, the Bank is prepared to suggest that growth has already returned to trend. That was before the Q4 GDP data had been available and emphasises the importance it gives to "labour market data and a range of business surveys" and, possibly, its reduced confidence in the GDP series.

The December quarter GDP release was a little stronger than we expected although government spending added 0.9ppt's to growth – GDP overall increased by "only" 0.9 per cent. All measures GDP(E); GDP(I) and GDP(P) printed 0.9 per cent. It is more reliable to assess the government component as its contribution to growth in domestic demand (2 per cent) so we can conclude that the direct effect of government spending explained around 50 per cent of the growth in domestic demand. Further, a large part of the 11 per cent increase in equipment investment (contributed 0.8ppt's to domestic demand growth) was due to government tax incentives.

The surprising aspect of the GDP release was the 4 per cent contraction in dwelling investment. That is despite dwelling investment growing by 4.7 per cent in the September quarter and residential building approvals surging by 44 per cent over the course of 2009. The concern is that there might be some "crowding out" in the residential construction sector as the government's schools program gathers momentum.

While the government played an important role in supporting growth in the December quarter the issue for Australia is whether there is sufficient momentum in the private spending cycle to maintain the growth platform. In contrast with the US, where there must be serious concerns about the sustainability of the current growth surge, Australia's prospects look good. Labour markets are strengthening; business confidence and investment intentions are buoyant; consumers are confident; house prices are rising; and the terms of trade are on the rise.

In last week's note we pointed out that despite ongoing global uncertainty the RBA would still decide to raise the cash rate at its March Board meeting. We gave emphasis to two main themes. Firstly, we expected the Bank to be concerned about the possible inflationary implications of the unexpected strength of the labour market. We assessed that Australia's NAIRU (the non accelerating rate of unemployment) is 5 per cent, very close to the current unemployment rate of 5.3 per cent. We noted: "Central banks should be uncomfortable when the unemployment rate is close to the NAIRU and heading down while rates are below neutral".

The risk for the markets view that the next hike is not expected till July will come with next week's employment release. Consensus forecasts are reasonably expected to centre around a 10,000 – 15,000 increase in employment with a steady unemployment rate. Scrutiny of history shows us that the Consensus forecast on the employment series has been woefully astray over the last 5 years.

On our count there have been only nine months out of the last 60 when the Consensus has overestimated jobs growth by more than 10,000 while there have been 36 occasions when it has underestimated the series by 10,000 or more. Next week represents another risk event when the unemployment rate may move even more uncomfortably close to the NAIRU. We don't think the RBA will feel as comfortable to keep rates below neutral if another large step is taken towards NAIRU.

The second reason we gave for the RBA deciding to move was our assessment of inflation risks. Our research is showing that the strengthening of demand has allowed retailers to widen margins for discretionary items. This is showing up in the strongest annual growth in our discretionary items index of the CPI for almost nine years. Further evidence of this following the release of the March quarter CPI might be enough to motivate the Bank to tighten further after only two months following the release of the March quarter CPI on April 28.

It is interesting that consistent with the February Statement, the Bank was only prepared to assess that inflation is expected to be consistent with the target in 2010. With policy affecting inflation with a one year lag, it will be necessary for the Bank to express confidence about 2011 inflation over the next couple of months. A continuation of the trends we are seeing may indicate to the Bank that another move in May will be necessary to justify confidence that inflation in 2011 will be consistent with the target.

Bill Evans is chief economist at Westpac.

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