Westpac Predict Rates on Hold till 2011

The Reserve Bank Board meets on August 3. With the surprisingly low inflation read for the June quarter (see below) there is no chance of a change in interest rates from this meeting. The underlying inflation read for the quarter printed 0.5% while the headline number printed 0.6%.

It goes without saying that the number came as an extraordinary surprise. Westpac’s forecasts for trimmed mean and headline inflation were both at 0.9%qtr. Market consensus was 0.8%qtr and 1.0%qtr respectively. We have to go all the way back to the December quarter of 2006 to recall a similar massive surprise, when the trimmed mean printed 0.5%qtr and the headline printed –0.1%qtr. At the time, the RBA was uncomfortable with the outlook for inflation, but duly kept rates on hold between November 2006 and August 2007. The Bank was later to regret that decision because inflation pressures built rapidly through the second half of 2007 with core inflation peaking at around 4.7%yr in 2008.

Nevertheless, the RBA is set to use the information from this release to keep rates on hold at the meeting on August 3, and most likely for the remainder of 2010. Our previous view had been that a high print would have indicated uncomfortably strong momentum in inflation which would have required rate hikes in both August and November. The extraordinarily low print means that momentum in 2010H1 is running at a 2.6% annualised pace, comfortably in line with the Bank’s forecast for 2010 of 2.75%. Even if the September quarter report shows a return to that 0.8%qtr pace (recall that prior to the June quarter print, ten of the last twelve quarterly underlying inflation prints were 0.8% or higher) the evidence would not be sufficiently convincing from the inflation profile alone to raise rates in November.

It has to be our view therefore that rates will now remain on hold for the remainder of the year.

Our previous view had been that the economy is currently facing a range of headwinds including constrained credit growth, contractionary fiscal policy, a more cautious consumer, a higher Australian dollar, and a surprising reversal in confidence about the housing market. However, we expected that the dominant headwind was going to be a central bank dealing with short term inflation pressures and raising rates by another 50bp over the course of the remainder of 2010.

That range of headwinds would have been sufficient, despite a resurgence in business investment, to keep rates largely on hold through the course of 2011.

Now, with rates likely to be on hold for the foreseeable future, consumer confidence, business confidence, housing and most likely the labour market will be gradually boosted.

The risk to a November rate hike would be if the labour market tightened more rapidly over the course of the next few months than we expect therefore unnerving the Bank. We have revised up our estimates of demand momentum over the course of 2010 to reflect steady rates but, on balance, do not believe that momentum will be sufficiently strong to lead to the style of uncomfortable tightening in the labour market to require an imminent rate hike. However, a second quarter of stable rates is likely to sufficiently boost that momentum to see the next stage of the tightening cycle begin in February next year. That is likely to be complemented by a return to uncomfortable inflation reads. History shows us that with economic growth at least around trend for the course of 2010 a sequence of very low inflation reads is very unlikely.

Interest rates are still only at neutral levels, so given this scenario, it is now much more likely that the tightening cycle will resume sometime in 2011. By then, the Chinese economy will have restored its upward momentum, labour markets will be uncomfortably tight, and housing is likely to be staging a resurgence. Even economies like the US and Europe will have had another six to twelve months to work through their chronic imbalances.

Our forecast is for an overnight cash rate by the end of 2011 of 5.25%, but the monetary tightening is now much more likely to occur through the course of 2011 than being front end loaded in 2010 as we had previously expected.

Source Bill Evans Westpac Chief Economist


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