Why 2014 will be the year of the rate hike

Interest rates will be left alone by the Reserve Bank board today. But get ready for hikes in 2014 when inflation rises and the labour market turns around.

A hike in interest rates will not be seriously canvassed at today’s meeting of the board of the Reserve Bank of Australia as it almost inevitably decides that no change in the 2.5 per cent cash rate is appropriate for now. 

That said, the interest rate cutting cycle is all but over as the leading indicators for housing, global economic conditions, consumer sentiment, business confidence and exports are all turning higher. There are also some signs emerging that inflation is inching up, albeit from a very low base.

These dynamics suggest that the next move in interest rates will be up, with the Reserve Bank likely to move early in 2014.

The main factor causing the RBA to hold off an interest rate increase at the moment is the lagging indicator of the economy – the labour market.

Employment always turns many months after the business cycle changes momentum. It takes a while for firms to realise that an economic upswing, for example, is being sustained before they lock in new hiring. It is a similarly delayed reaction whenever an economy slows.

The most recent labour force data confirmed small falls in employment in each of the last two months while the unemployment rate has edged up to a four year high of 5.8 per cent. For labour force conditions to improve, the economy needs to pick up to a 3 per cent growth pace, which is now looking more likely than not for year end.

Indeed, the economy is on track to lift to growth well above 3 per cent in 2014, but it is not quite there yet, which means the central bank will hold off lifting interest rates for now.

Importantly, inflation is currently well contained, anchored in the bottom half of the 2 to 3 per cent target band. As an inflation targeting central bank, the RBA can leave monetary policy settings at a highly accommodative level until it starts to forecast some inflation pressures unfolding.

That said, there are already some hints of higher inflation coming through in the TD-MI monthly inflation gauge, which rose 0.2 per cent in September, after increases of 0.1 and 0.5 per cent in the prior two months. Inflation in the last three months is running at an annualised pace of 3 per cent, and while there may be some seasonality in the data, another couple of 0.2 or 0.3 per cent monthly increases would be a clear signal inflation was starting to be uncomfortable.

The September quarter CPI, to be released later this month, is likely to show a quarterly increase of 0.9 per cent with underlying inflation at 0.7 per cent. If so, it would confirm higher inflation already getting etched into the economy.

The check list of economic indicators has a growing list of items in the 'strong' column.

House prices are rising at an accelerating rate. While there is nothing much to be too concerned about at the moment, another few months of 1.5 per cent gains will see the Reserve Bank working to stop it turning into problem. The easy solution to address excessive house price gains or even nip them in the bud is to hike interest rates. Interest rate hikes are a cheap, easy and transparent policy approach to dampening demand for housing.

The Westpac index of consumer sentiment is now around 10 per cent above its long run average, which is usually a precursor to solid growth in household consumption expenditure. If annual growth in household consumption lifts to 3.5 per cent or more, which seems likely, bottom-line GDP growth will almost certainly exceed 3 per cent and the unemployment rate will then start to fall.

Business sentiment is also lifting. The release this morning of the Dun & Bradstreet business expectations survey shows a clear turn in expected profits, sales, investment and a less negative outlook for employment. The NAB business survey results are also showing a lift in confidence, which bodes well for the hard economic data into the final months of 2013 and into 2014. 

While there are still some uncertainties surrounding the global economic outlook, the run of economic news from China, the eurozone and the US has matched or exceeded most expectations from earlier in 2013. For Australia, this is showing up in ongoing export growth, a stabilisation in commodity prices and market confidence with a strong lift in share prices. 

While rates will be on hold today and probably remain that way for the next couple of months, it remains a strong probability that 2014 will be the year of interest rate hikes. The first of those moves looks set for February after the inflation rate moves up and by which time there are likely to be clear signs of a turn in the labour market.

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