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(March-2004) Punters bet Bank takes a hike
Recent polls by financial market participants (such as published surveys from Bloomberg and Reuters) indicated that a majority of observers expect another Reserve Bank of Australia (RBA) rate increase in March to take our cash rate to 5.50 per cent.
This prospect has attracted a number of critics, notably from the housing industry and the rural sector.
Three main factors seem to lie behind this criticism:
n The steep and contractionary upswing in the Australian dollar, to 15-year highs in nominal Trade Weighted Index (TWI) terms and over 30 per cent appreciation against the US Dollar in 12 months;
n Another low consumer price index (CPI), with Treasurer Peter Costello helpfully observing that the result is “ well within the medium term inflation cycle”; and
n Suggestions that some heat has come out of the housing market in recent months.
Whether or not this purported rate rise occurs after this Super Review issue goes to print, it is worth understanding how the RBA thinks when looking at the market place before making a decision on interest rates.
The RBA increases in the December quarter 2003, in the face of an apparently benign inflation story, led to the widespread assumption that it was targeting the “housing bubble” rather than inflation.
But the RBA says it is tightening for inflation-targeting reasons — these being the high and rising levels of resource utilisation which are consistent with rising prices and falling unemployment.
The RBA is at pains to point out that it targets future inflation, not current inflation. The key to understanding RBA policy lies in coming to grips with its medium-term inflation outlook.
The basic theory here is that as above-trend growth increases, wage and price pressures tend to intensify. Policy makers respond with higher interest rates to “pre-empt” growing inflation problems. The three previous tightening cycles in Australia, in the late 1980s, late-1994 and 1999-2000, were associated with growing wage and price pressures.
However, in the current cycle, the acceleration in wages growth has been quite modest so far. That is why despite the strong economic growth we have enjoyed in recent years, the cash rate so far is low. Indeed, the current RBA tightening cycle so far is the most cautious in modern history.
Looking further out, there’s a widespread expectation that the RBA’s tightening cycle is nearly complete. These sorts of scenarios are interesting because they have rates peaking without ever getting to the top of the 5 to 6 per cent range the RBA labels as “neutral”.
It is very possible that the RBA will remain on hold at 5.25 to 5.5 per cent for the foreseeable future (with variable mortgage rates steady around 7 per cent or so).
The need for a second phase of RBA tightening — to a “restrictive” stance — would eventuate if the economy continues to go at an above-trend pace for another year or two.
In such circumstances, RBA cash could be lifted into a 6 to 6.5 per cent range (with variable mortgage rates heading towards 8 per cent or so). The most obvious sign suggesting a need for such tightening would be a clear acceleration in wages growth. The odds of this happening currently appear to be low.
The latest quarterly statement from the RBA highlights the strong momentum in the economy, with over a decade of sustained growth.
In particular, it cites the fact that real retail spending over the second half of 2003 is the strongest in two decades, while the unemployment rate at 5.6 per cent is the lowest in two decades, and our terms of trade (export prices relative to import prices) are at “their highest level in 25 years”.
Intermediary credit growth over 2003 was its strongest in over a decade, and signs of softening are so far only “tentative”. Consumer confidence and non-farm business conditions are at their highest levels in a decade, with sentiment about personal finances in the year ahead the most upbeat in three decades.
Household debt servicing has now become a closer area of watch by the RBA. Debt servicing, as a proportion of household income, has now probably surpassed its late 1980s peak. Household interest payments, as a proportion of available income, are the same level now with cash rates at 5.25 per cent as they were when the cash rate topped 18 per cent.
Further, tightening by the RBA will rapidly reach a point of significant constraint for householders. There is a very delicate balance now between constraining credit growth and causing damage to household cashflow from tightening.
The other area of watch is the ongoing appreciation of the Australian dollar (associated with devaluation in the US dollar). The RBA described the recent 15 year high in the TWI as “noticeably above its long-run average”.
The contradictory force of the sharp upswing in the TWI has dampened somewhat the outlook for both growth and inflation. The weakness in the TWI explicitly boosted the case for tightening in April and May 2000; with the issue now a sharp rise, the pressure from the TWI on policy is running the other way. This could further alleviate the need for increasing rates.
— John Honan is chief economist with Ausbil Dexia
AUTHOR
Mike Taylor
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