Reserve Bank returns to watchful stance


RBA Statement on Monetary Policy; PCI

  • The Reserve Bank has tinkered with economic growth forecasts, but the trajectory is largely unchanged. However the Reserve Bank has modestly downgraded inflation forecasts. The economy is tipped to grow by 3.50-3.75 per cent over 2011 and 3.75-4.00 per cent over 2012. Underlying inflation is tipped to be around 2.50 per cent over the period to June 2011 and to lift to 2.75 per cent in the year to June 2012.
  • It is clear from the latest monetary policy statement that this week’s rate hike was very much a strategic decision. While inflation is expected to remain in the Reserve Bank’s 2-3 per cent target range, the Bank wanted to take out some fresh insurance that inflation would stay there – “early and modest” rate hike. The Reserve Bank has now returned to ‘wait and see mode’ – no imminent rate move is flagged.
  • The Reserve Bank assumes higher interest rates in making its inflation and growth forecasts. The Bank should follow the lead of Reserve Bank New Zealand and more explicitly state its interest rate
  • The construction sector continued to contract in October. The Performance of Construction index stood at 44.0 in October, below the reading of 50 that separates expansion from contraction.

What does it all mean?

  • This week’s rate hike was clearly strategic. As we expected, the Reserve Bank has actually trimmed its inflation forecast. But despite that move it still decided to lift rates anyway. Clearly the inflation forecast was predicated on the assumption of some lift in interest rates. The Reserve Bank decided to lift rates now, rather than later, as a pre-emptive strike against inflation. As the old adage goes, ‘a stitch in time saves nine’. Perhaps that small rate hike will prevent rates from rising higher than originally expected over 2011.
  • The latest rate hike certainly took the market by surprise and the justification by the Reserve Bank for the rise in rates was squarely placed on concerns about future inflation. The release of the latest Monetary Policy Statement highlights the Reserve Bank’s thinking on inflation and it seems that inflation is not expected to be a major concern until 2012. Inflation forecasts have been downgraded with both the core and underlying measures comfortably holding with the Reserve Bank’s target band.
  • What we don’t know is how much monetary tightening is assumed in 2011 to ensure that inflation remains in the target band. The Reserve Bank merely says that it bases its views on market expectations for interest rates. The problem is that the overnight indexed swap rate is assuming a 5.00 per cent cash rate in a year’s time but market economists assume a cash rate of 5.50 per cent.
  • The Reserve Bank notes that higher interest rates will be the key driver in ensuring a low inflation era. The Australian public would like to know what those rate assumptions are. Clearly it would be beneficial for Australian businesses and consumers if the Reserve Bank released its interest rate forecasts, similar to other central banks like the Reserve Bank of New Zealand. The release of interest rate assumptions would be the next step in the evolution process for monetary policy setting in Australia. The Reserve Bank now releases statements after each meeting and Board minutes – the next step is releasing its interest rate assumptions.
  • The Reserve Bank currently doesn’t have a single ‘hot button’ factor – it is watching everything. Food prices, wages, the Australian dollar, consumer conservatism and global factors are all being closely watched. Certainly there is no indication that rates will have to rise further – not yet, anyway. The Reserve Bank has returned to watching – and it is watching everything.
  • The data over the past week, has painted a picture of an economy that is far from robust. Building approvals continue to slide, retail sales are soft, manufacturing exports and new orders are sliding and the construction sector is still contracting. And given the additional rate increases by the banks the RBA may face an extended period on the monetary policy sidelines.

Key quotes and observations from the statement

  • Rate Decision: “Over the past couple of months, economic developments appear to have been broadly in line with the Bank’s central scenario, and the downside risks in Asia look to have lessened a little. As a result, at its November meeting the Board concluded that it was prudent to make an early and modest adjustment to monetary policy, increasing the cash rate to 4.75 per cent.”
  • Rate outlook: “Money market yields suggest markets currently expect a further increase in the cash rate in the first half of 2011.”
  • Central forecast: “The outlook is positive, supported by the expected strong growth in investment in the resources sector, the income boost flowing from the elevated level of commodity prices and ongoing solid population growth, albeit at a reduced pace relative to the high rate of around a year ago. With the economy having limited spare capacity, there is likely to be an increase in inflationary pressures over the forecast period.”
  • Economic forecast: “GDP growth is expected to be around trend for 2010. It is then forecast to pick up to a slightly above-average pace in 2011 and through to the end of the forecast period in June 2013.”
  • Inflation: “The proportion of expenditure classes recording annualised price rises of more than 2.5 per cent (by weight and seasonally adjusted) remained at around 40 per cent in the September quarter, which is low relative to outcomes over the past decade.”
  • Inflation forecast: “The near-term forecast for year-ended inflation is a little lower than at the time of the August Statement. This is largely due to the recent appreciation of the exchange rate and the effect of the slightly lowerthan- expected September quarter outcome.”
  • Inflation forecast (again): “The bulk of the disinflationary effects from the slowdown are likely to have passed, and the subsequent strengthening in economic conditions and the labour market is expected to lead to a gradual pickup in inflation in the medium term.”
  • Risks: There is a risk posed by the timing of resource projects – that could impact on the profile of GDP growth. Another risk relates to the caution by consumers – if this waned and there was a ramp up in mining projects, this combination could boost wages and prices. There are upside risks for Asian economies, especially China. There are downside risks for advanced nations.
  • Downside risk: “If developments in global financial markets resulted in a significant further appreciation (of the Aussie dollar) that was unrelated to these factors (higher commodity prices and interest rate differential), it would likely result in both growth and inflation being lower than in the central forecast.”
  • Business caution: “Outside of the mining sector, liaison indicates that a degree of caution still characterises firms’ spending decisions, with confidence and investment intentions around average levels.”
  • Bank funding costs: “The average cost of the major banks’ long-term funding continues to rise as maturities are rolled over at higher spreads.”
  • Home building: “…the pick-up in housing construction is moderate by historical standards, especially given strong demand for housing from a growing population.”
  • Wages: “Measures of wage growth have risen in 2010, after the subdued outcomes in 2009. Despite this pickup, wage growth in the private sector was slightly below average over the first half of 2010, while in the public sector, wages have continued to grow at a slightly above-average pace. Looking forward, a further increase in wage growth is expected over time, as the labour market tightens further.”
  • Cautious consumers: “…the Bank’s liaison continues to suggest that consumers are cautious in their spending. The appetite for new debt also remains more subdued than in the past, with both housing and credit card debt currently growing at historically low rates. This has been associated with a welcome cooling in the housing market, with dwelling prices declining slightly over recent months, after increasing solidly over the year to the March quarter.”
  • Labour supply: “Despite a high level of vacancies and the relatively low unemployment rate, firms in most industries are not reporting unusual difficulties in hiring suitable labour. The main exceptions are in some miningrelated occupations, where the labour market is quite tight.”
  • Labour supply (again): “In business surveys and the Bank’s liaison, most firms are reporting that finding labour is currently not a major issue; the difficulty of obtaining suitable labour has risen to a little above average levels, though it remains well below its level prior to the downturn when the labour market was tight.”
  • Business sector: “Conditions in the business sector are broadly favourable, although there is considerable variation across industries.” And further: “Outside of the mining sector, investment intentions are around average levels and the Bank’s liaison suggests that firms remain cautious in their spending decisions.”

Other Economic Data

  • The Performance of Construction index rose by 3.2 points to 44.0 in October. A reading below 50 indicatesthat the construction sector is contracting. The construction sector has now been contracting for five consecutivemonths. The key forward-looking indicators were still weak. New orders rose by 4.1 points to 42.4. Employmentrose by 1.1 points to 45.1. Input costs rose sharply partially offset by a rise in selling prices. The housing,apartment and commercial indexes all continued to show declines.

What is the importance of the economic data?

  • The Reserve Bank releases its Statement on Monetary Policy each quarter. The Statement is the Reserve Bank’s assessment of economic and financial conditions and also contains the latest inflation views. The Statement is crucial is assessing the short-term outlook for interest rates.
  • The Performance of Construction index is released by Australian Industry Group and the Housing Industry Association each month. The PCI is designed to provide a guide to conditions in residential, commercial and engineering construction sectors.

What are the implications for interest rates and investors?

  • The Reserve Bank expects inflation to remain in its target band over the next year. What we don’t know is how much – if any – monetary policy tightening is assumed to keep the economy on the straight and narrow.
  • The Reserve Bank is not signalling any near-term rate hike. Rates look to be on hold until February 2011.
  • If the economy evolves as the Reserve Bank expects it will be very positive for investors – firm economic growth and contained inflation.

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