Why rates have no further to fall

The interest rate cutting cycle in Australia is over.

At least it appears to be, based not so much on hard local news, but more on an unambiguous up-turn in global economic and market conditions and the yet to be felt effects of earlier monetary policy easings from the Reserve Bank.

To that end, I think I was wrong.

The case for having the cash rate lower than the current 3 per cent is still robust, based on the low inflation environment, the high Australian dollar and a softer labour market. But all of that news has been around for a while and the Reserve Bank has shown it has other issues in its focus when setting interest rates.

Among those issues that RBA Governor Glenn Stevens mentioned in December, when he cut rates by 25 basis points, are the still high terms of trade, improving sentiment in financial markets, close to trend growth domestically, an improvement in dwelling investment and higher house prices. Since Stevens' statement almost two months ago, the positive tone of these indicators has unambiguously lifted – in some cases by a lot.

Some of the issues that encouraged the bank to cut rates in December have either improved a little or are no worse. This is particularly so for "below average global growth”, a subdued outlook for non-residential building, a softening labour market and inflation being consistent with the target (NB: the December quarter CPI is released tomorrow).

In other words, the economic and markets news has materially improved since December, when the Reserve Bank said: "While the full effects of earlier measures are yet to be observed, the board judged at today's meeting that a further easing in the stance of monetary policy was appropriate now”.

Yesterday I outlined the unambiguous improvement in global conditions (High fives for a five-year high, January 21). This is a critical aspect in Reserve Bank thinking and will have a huge influence on its policy orientation.

In terms of the things that matter domestically, the bank will be looking at the recent lift in house prices with some trepidation. Since the end of 2012, house prices are up, according to RP Data, by a noticeable 1.3 per cent. While this rise follows two years of sluggish house price movements and is likely to have some seasonality to it, a massive improvement in affordability is likely to trigger further house price gains. While some house price rises are non-controversial, a more rapid lift in house prices would be something it would prefer to avoid. Refraining from overdoing easy monetary policy is one way to reduce the risk of this.

In addition to the global and house price news, house building approvals are trending higher, consumer sentiment is firm, share prices are strong, commodity prices have ticked higher, car sales are booming, and the mining sector still appears to be strong. And while tomorrow's CPI is likely to confirm a low inflation rate for the December quarter, the TD-MI monthly inflation gauge has shown an uptrend in inflation in December which does not bode well for inflation in the early part of 2013.

There are some important points to make about the Australian dollar and its influence on Reserve Bank monetary policy decisions. While just about every analyst, including those at the bank, judged the Australian dollar to be overvalued in the latter months of 2012, the fact that it has been broadly stable while commodity prices have kicked higher has eroded some of this overvaluation.

Indeed, the Australian dollar overvaluation is no longer all that extreme. When the iron ore prices plumbed below $US90 a tonne nearly four months ago, the unit was trading around $US1.02 to $1.04. With iron ore prices up some 70 per cent since then, it is this morning around $US1.05 – a point which significantly dilutes the overvaluation estimates. In US dollar terms, the Reserve Bank index of commodity prices is higher now than in October, a point that again softens the Australian dollar overvaluation story.

Curiously, there are many analysts expecting aggressive interest rate cuts. Indeed, some banks have, in recent weeks, altered their monetary policy forecasts to call 75 or 100 basis points of rate cuts over the course of 2013, reversing their earlier stance of modest or no cuts in the year ahead.

According to the latest Bloomberg survey, 100 basis points of rate cuts by year end are forecast by ANZ and Macquarie, while 75 basis points of cuts are forecast by Deutsche Bank, Goldman Sachs and NAB. These forecasts may yet prove to be close to the mark, but it seems they are too pessimistic. The economy has been surprisingly robust in recent times.

There is only one forecaster surveyed by Bloomberg who reckons there will be an interest rate hike this year. The ever hawkish Paul Bloxham, HSBC's chief economist, reckons the Reserve Bank will not only be on hold for the first three quarters of 2013, but could well hike rates during the December quarter.

Given the unfolding evidence brewing, it is hard to argue with that view.

But this far out, is very hard to pinpoint when the first hike in the cycle will be, as it could easily be nine to 12 to 18 months away. Put another way, the Reserve Bank will likely be in a hiking mode when the unemployment looks like trending back towards 5 per cent, when global conditions have the markets speculating about the end of quantitative easing and perhaps when commodity prices are 10 per cent higher than now. It won't happen overnight, but it probably will happen.