WEEKEND ECONOMIST: The next hike

Following the RBA's announcement, markets quickly moved to price in a probability of around 60 per cent for a November move and 150 per cent for a December rise. Following Thursday's labour market data showing an extraordinary increase in employment in September of 40,600 (versus consensus of a 10,000 fall) markets are now giving a 110 per cent probability of a 25 basis point rate hike in November and 200 per cent for December – the market now sees hikes in both November and December as certainties. There is even some speculation that rates will be increased by 50 basis points in November, although this prospect is currently being given little chance by the market.

We certainly concur with that assessment. While we recognise the strong recent record of market pricing we are reluctant to follow the market into forecasting a third rate hike in December.

Firstly, we are somewhat sceptical about the monthly jobs data. The chart below shows the extraordinary volatility of the monthly jobs reports in recent times.



The "pattern" that has been established for some months is that large negatives have followed large positives in every report since April. Significantly, this April/September period covered part of the time when the sample size had been reduced to 0.24 per cent of the population. The sample size is now to be progressively restored (over four months) to almost double (0.45 per cent of the population) starting with the September report – along with risks associated with the smaller sample a further source of instability may be associated with this first stage of the upward adjustment of the sample size.

Additional curious aspects of this series relate to a cross check with the state numbers. The sum of reported state changes in employment was only 22,900 (compared to the 40,600 national number) with 70 per cent of the rise being in South Australia.

Accordingly, we expect a technical correction with a number around minus 30,000 for the October jobs report (due out on November 11). That is likely to push the unemployment rate to 6 per cent from 5.7 per cent.

Another complicating aspect to the decision by the RBA on December 3 will be that the September quarter GDP data will print the following day. We are currently expecting domestic demand to contract by 0.4 per cent. A positive GDP result of 0.3 per cent will only be delivered by a forecast 1.5 percentage points contribution to growth from inventories as firms rebuild stocks following three successive quarters of running them down. Such is the unpredictability of the inventory cycle that we could easily be overestimating the degree of inventory rebuilding and GDP could print negative for the September quarter.

We accept that the guidelines being used by this current RBA Board are somewhat more decisive than under previous Boards and that Boards must be forward looking. However, note that since the Bank began announcing rate moves we have never seen rate hikes in three consecutive months. Even a forward looking Board might be uncomfortable with an unprecedented third consecutive tightening preceding a negative print on GDP.

While, at this stage, we are comfortable to defer the December rate hike due to our concerns about the volatility of the job numbers we have revised our unemployment profile. We do recognise the broad message from the September jobs report. We had been expecting total job losses for the September/December period of 50,000. Even with our expected technical correction to the September number in October we are still now forecasting a modest increase in jobs over that period of around 10,000.

While jobs growth will be insufficient to contain a rise in the unemployment rate to around 6.5 per cent (from 5.7 per cent) in Q3 2010, we expect that the period of job losses has essentially passed, although the unemployment rate will still rise since new jobs of around 15,000 are required to hold the unemployment rate steady in any month.

The chart below sets out our revised profile for the unemployment rate.


This more moderate profile for the labour market may delay the timing of the "pause" which we assess the RBA will adopt at some point around the middle of 2010. We have expected the pause to begin around May next year once the cash rate reaches 4 per cent. The risks now point to that pause coming later off a higher (4.5 per cent) final cash rate.

However, our views on the most important "forces" supporting that pause – global growth; global capital markets; ongoing domestic credit difficulties; households' sensitivity to rising mortgage rates; businesses' concerns with ongoing tight credit conditions; and a rising unemployment rate (albeit at a slower pace) – have not changed.

On balance, for the time being, that points to us retaining our 4 per cent cash rate peak forecast for the first stage of the cycle with clear emphasis on upside risks.

Bill Evans is chief economist at Westpac.