Rates To Rise?

The Reserve Bank of Australia (RBA) moved to a neutral stance on official interest rates with the recent Statement on Monetary Policy and appearance of senior RBA officials before the House of Representatives Economics Committee. The RBA governor Ian Macfarlane articulated the view with his comment that:

“There is a 50% chance that the next move might be up and a 50% chance that it might be down.”

By definition, there is a zero chance of interest rates being held steady. The question now, as ever, is which direction interest rates are more likely to move and when that move is likely to occur.

Before we address those issues, it is important to note that the RBA moved to a neutral view on interest rates because upstream price pressures were less severe than it feared, the Consumer Price Index (CPI) results had been comfortably low in recent quarters, the housing market is weak, household spending had 'consolidated’ at a lower level and credit growth has slowed.

In highlighting these points, the RBA appears to be downplaying future inflation and wage risks. What’s more, there is now evidence that consumer demand and housing are recovering and there is a boom in export growth which is fueling corporate profits, national income and the stock market.

In our view, the data over the last month or two has been strong, suggesting that the RBA will return to its tightening bias in the not too distant future. It could even move to hike interest rates by year end if the economy accelerates further and wages and inflation pressures remain to the upside, as indicated in recent monthly inflation and quarterly wages data.

With the short end bank bill yields priced for an interest rate cut, we would expect the following market trends to emerge in the months ahead:

• Short dated yields to move higher.
• Three years bonds to also move higher in yield.
• The yield curve to flatten and then invert.
• The A$ to strengthen.

If the RBA is to increase official interest rates, when would it do it?

6 September 05
1% possibility. It is too close to the RBA’s recent conversion to interest rate neutrality for it to hike interest rates. Admittedly, there will be news on capital spending (CAPEX), retail trade, building approvals and monthly inflation to guide it in two weeks time, but these data would need to be block-busters for it to even give vague consideration to hiking rates so soon.

4 October 05
20% possibility. The Q2 GDP results, for release on 7 September, will form the base from which the RBA and Treasury will revise its medium term forecasts. Current indicators point to a reasonably firm GDP outcome (0.9%q/q) which should set the foundations for forecasts that point to an economic recovery and further employment and wages pressures.

The monthly inflation data for September (released 30 September) will allow the RBA to judge the risks for Q3 inflation. Important for monetary policy will be the labour market indicators. If the unemployment rate, currently at a three decade low of 5.0% falls further, wages and monetary policy risks are clearly to the high side.

1 November
35% possibility. This is where it gets interesting. The RBA Board meeting on 1 November will have before it the news that released earlier that morning that the US Federal Reserve has hiked the US cash rate to 4.0%. Also for consideration will be the Q3 CPI, released the week before the November meeting, which is likely to confirm headline inflation above 1.0% for the quarter and 3% for the year – the core inflation readings are also likely to show an acceleration in inflation towards 3%. In its recent statements, the RBA acknowledged that inflation pressures are building, but its forecasts suggested that inflation would not hit 3% until the second half of 2006.

If it gets there in the Q3 2005, the RBA may be nervous about the momentum in inflation over the year ahead. The next few monthly inflation results, plus the Q3 CPI will be critical. The RBA tends not to hike in November as there have been only four rate changes in November in the past 15 years. The RBA will release its next quarterly Statement on Monetary Policy on 7 November, less than a week after its meeting. If it wanted to outline details for the hike, the SMP might be a good option.

6 December
50% possibility. The RBA likes December for interest rate adjustments. There have been 6 moves in 15 years, plus two moves in January (pseudo December moves, it would seem). December is a favoured month to adjust monetary policy because the RBA has usually more useful information to work on. This year, however, the Q3 National Accounts are not released until the day after the Board meeting. This may be a mild hindrance for the RBA, but as we have seen in the past, it is not shy from adjusting rates some 2 hours before the National Accounts data are released.

What should be important is the information for the December Board meeting are Q4 wages results – the Labour Price Index is out on 16 November. Will the 5% unemployment rate spark a further acceleration wages? If so, it’s “game on” for December.

BEYOND THAT

It is too difficult to make hard and fast calls beyond this period. Indeed, it is usually not very enlightening to make such long dated projections on monetary policy and financial markets given the range of issues that can influence the growth and inflation outlook.

For Australia over the next six months, housing could be a problem on the down side, while the risks from a Chinese growth slowdown are very real, particularly if it causes the Australian export rebound to be short lived.
On the other hand, wages and inflation could be accelerating to uncomfortable levels and consumer demand is on track to recover.

For now, the risks of a solid economic pick up with wage and inflation pressures are dominating the downside factors that might eventually lead to a containment of price pressures. And while that’s the case, there is not much chance of an interest rate cut and the market might start to price in rate hikes by the time the Q2 GDP results are released on 7 September.

Stephen Koukoulas is the chief strategist Asia Pacific at stockbroker TD Securities.