Sunday, February 7, 2010

Australian Economic Update

Australian Economic Update
RBA surprises – cash rate steady at 3.75%
The Reserve Bank today surprised just about everyone by leaving the cash rate steady at 3.75%, having hiked after each of the last three Board meetings - local market economists were unanimous that the cash rate would rise today. Officials once again delivered an upbeat commentary, but seem to have baulked at some of the jitters in financial markets on the back of recent news about sovereign exposures. Also, there are clues in the commentary that the RBA is content to have the major commercial banks, each of which out-hiked the RBA in December, to do their share of the heavy lifting.
Given that the RBA did not tighten, the upbeat tone of the commentary is a surprise. It is an echo of the December statement, with officials highlighting, in particular, that economic conditions in Australia (and, for that matter, our major trading partners in Asia) have been unexpectedly firm. If anything, the wording on Australia’s economic conditions is even more upbeat than before. Indeed, just about every data point released since the December meeting has been firmer than expected. Even the commentary on conditions offshore generally is positive, except for the deliberate insertion of reference to concerns about “some sovereigns”.
The main takeaway from the statement is at the end, where the RBA makes clear that interest rates remain low and probably will have to be adjusted (i.e. raised) for inflation to remain consistent with target. There is a chance that the RBA simply rolls forward the rate hike we expected today to the next meeting scheduled for early March. More likely, though, is that, given that officials are feeling sufficiently cautious to be tactically on hold today, they probably will be equally cautious in one month’s time. We, therefore, look for the next hike to come in early April, but for a resumption of a steady tightening cycle over the second half of this year.

Officials clearly are in no rush to return policy to “neutral”, which remains some way off. Our estimate of “neutral”, taking account of the impact of wider bank margins and proposed bank liquidity changes (offset to some extent by our assumption of faster growth in Australia’s population and productivity, which will boost potential growth) is a cash rate of between 4.5% and 5%. That said, there is considerable flexibility over what level of the cash rate is consistent withneutral – it could well be outside this range. Indeed, as RBA officials have made clear, a neutral stance is hard to identify, but you usually know it when you get there.

What is clear is that the cash rate is back in a “normal” range - the emergency component is gone; the RBA’s Deputy Governor made this clear in a speech back in December. What also is clear now is that the return to normality opened the door for officials to slow the pace of tightening. Indeed, having front-loaded the first stage of the return to neutral, we suspect RBA officials will extend the break they started today for at least another month. They will use this interval to gather more information on the strength of the global economy and markets and test the all-important resilience of the Aussie consumer in the wake of assertive rises in market interest rate rises since October.

On the domestic economy, the statement highlights that while the impact of the fiscal boost on the consumer is fading, the strong labour market and recovery in net worth (i.e. there was no mention of falling equity markets) are supporting household finances. The statement refers to the positive impact of rising public spending on infrastructure, along with an upturn in home construction. Investment in mining is “strong” and the rate of unemployment “appears to have peaked”. I challenge anyone to find a note of caution in any of that. On global economic conditions, the recovery in Asia “has been much quicker to date”, so much so that the authorities in China have moved to slow growth.
On inflation, officials seem content with their long-standing assumption that inflation will be consistent with target in 2010. Friday’s quarterly statement from the RBA will include the latest official forecasts on growth and inflation. We still believe that both will be pushed higher but, with officials likely to be reluctant to frighten the horses on the deteriorating inflation outlook, the upgrades probably will be limited to 0.25%-points over the forecast horizon. Even then, the official inflation forecasts will be below our own.

We continue to look for the cash rate to reach 5% by the end of 2010, which would leave the policy lever tilted slightly to “restrictive”. After today’s surprise outcome, however, more of the tightening now looks likely to come in the second half of the year. The troubling inflation outlook, in a framework where core inflation remains above the RBA’s 2-3% target range, means official probably will have to push policy further into restrictive territory in 2011.

[source J.P. Morgan Securities Inc.]

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