WEEKEND ECONOMIST: Watch banks, not the RBA

The most noteworthy event next week will not be the RBA raising the official cash rate by 25 basis points to 7.25 per cent (an outcome still being underpriced by the market at around an 80 per cent chance), but the extent to which financial intermediaries take the opportunity of the increase in official rates to pass on rising funding costs in a bid to maintain their crumbling lending margins. Wholesale credit spreads continue to widen and these higher funding costs will increasingly be passed on to borrowers. Australia is a price-taker in global capital markets and Australian borrowers are competing with the rest of the world for increasingly scarce liquidity, a fact seemingly lost on the bank-bashing economic populists.

Increases in retail lending rates in excess of the increase in official interest rates were one of the main considerations for the RBA in refraining from a 50 bp increase in February and the RBA will continue to look to market-led tightening to shoulder some of the burden that arguably should carried by the official cash rate. The RBA will see any additional market-led tightening as validating its earlier restraint, but the RBA's reliance on unpredictable market-led increases in lending rates is part of what has left it so far behind the curve on inflation control.

This week's January private sector credit data showed overall credit growth running at 16.4 per cent year-on-year, close to the strongest rate seen since the peak of the last cycle in the late 1980s. This partly reflects the re-intermediation of bank lending at the expense of capital markets, but also suggests that higher credit costs are not yet unduly constraining credit growth. This was also very evident in this week's Q4 capex data, which confirmed a very strong outlook for investment spending, an outlook which presumably discounts the expected impact of higher credit costs. While the new government would have us believe the former government presided over chronic underinvestment, the reality is that the investment share of GDP has been at post-war record highs in recent years (an argument the now opposition Coalition seemingly does not have the wit to make). This addition to the capital stock should eventually have a pay-off in easing inflation pressures, but the lead times on some of these projects can be considerable, with capex adding to short-run demand pressures.

Next week's data are not expected to offer any relief to the inflation or interest rate outlook. The February TD-MI inflation gauge is expected to rise 0.4 per cent month-on-month, taking the annual rate to a record 4.1 per cent year-on-year. While the Q4 business indicators and current account are likely to confirm a drag on Q4 GDP from both net exports and inventories, headline GDP growth is still likely to be running at 4 per cent year-on-year, above the RBA's forecasting assumption of 3.5 per cent.

January retail trade is seen posting a 0.6 per cent month-on-month gain, while building approvals are expected to bounce 3.4 per cent month-on-month after the previous month's disastrous 16 per cent month-on-month decline. The January trade balance is expected to post a record deficit of $A2,826 million, partly due to weather-related disruptions to coal and other exports, although much of this impact may not been seen until the February release. Note that RBA assistant governor Edey speaks on 'The Evolving Economic Outlook', while assistant governor Debelle speaks on 'Recent Developments in the Australian Bond Market', both on Wednesday.

Dr Stephen Kirchner is an independent financial market economist. His blog can be found at http://www.institutional-economics.com.