Westpac Predict RBA to Raise Home Loan Interest Rates by 25bps

RBA to raise rates home loan interest rates by 25bps – due to tightening labour markets & demand pressures on inflation.
Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.
The Reserve Bank Board meets next week on March 2. We expect that it will decide to raise the overnight cash rate by 25bps to 4%. Current market expectations put the probability of a move at about 50%. We believe that most meetings in 2010 will be ‘live’ in that there will be a genuine possibility of policy change and at least for the next few months a 50/50 prospect is entirely reasonable. Arguments in favour of a further pause are based around concerns with the global economic outlook and some recent weakness in local economic data – notably housing finance, retail sales, and wages. Our assessment is that the Bank’s central view is an optimistic one on China’s prospects of achieving a soft landing. Indeed the Bank welcomes the current move to less stimulatory policy settings in China improving the sustainability of the expansion. However the implications for global trade, confidence, and liquidity of a major European default would change that view with severe implications for Asia’s growth outlook. We expect that the RBA anticipates that European authorities will, having observed the Lehmann disaster, not try a similar ‘experiment’ in Europe. The facts are that the resources of the European Community and the IMF can, if so applied, avert any fears of a default crisis in Greece or any other European ‘basket case’. The Governor has now accepted that monetary policy needs to take account of imbalances in asset markets. However, the 13% increase in house prices over 2009 is unlikely to indicate a potential bubble. Housing credit growth is steady at around 7%; investors are not rushing into the market; and media ‘hype’ is not apparent – the usual hallmarks of a mania are simply not there. Strong population growth and ongoing housing shortages instead explain the recent surge in house prices. Moreover, prices at the lower end of the market have softened recently. The Bank also appears to be puzzled by the sharp contraction in business credit – down 7% over the last year – the sharpest contraction since the 1990s recession. Most of this fall can be explained by deleveraging and disintermediation as large corporate access the capital and equity markets rather than bank credit. However, credit to small business is quite flat, partly reflecting supply issues.
With these arguments in mind why do we expect the Bank to raise rates?
Of course the Bank has now recalibrated neutral to be 4.25% to 4.75%. That was confirmed in the Governor’s recent appearance before the Parliamentary Committee on Economics. That testimony made it clear that the Bank expects to restore rates to neutral sometime in 2010. It may not have as much time as it expected even as recently as at the last Board meeting on February 2. The Bank’s public view on unemployment is that it has peaked at 5.8% but that the reduction in the unemployment rate will be modest over the course of 2010. The thinking is that the pick-up in labour demand associated with the buoyant economic conditions will be mainly accommodated by increases in hours worked rather than in new jobs. However, this has not been borne out in the data so far. The unemployment rate has fallen sharply from 5.8% to 5.3% in just three months. We have even seen decent full time jobs growth. Australia’s NAIRU – the non-accelerating inflation rate of unemployment – is around 5%, very close to the current unemployment rate. Central banks should be uncomfortable when the unemployment rate is close to the NAIRU and heading down while rates are below neutral. Current trends in the unemployment rate highlight the risk that Australian unemployment could be below its NAIRU by midyear. With markets and the media primed for a rate hike last month the Bank is likely to take advantage of these expectations to nudge the cash rate further towards neutral next week. If the RBA does choose another pause, expectations are likely to shift to ‘waiting for the CPI’, which will print in late April. We do not expect that the Bank will want to return to the previous approach of setting policy in response to the latest CPI result. We expect policy to remain forward looking. Meanwhile the outlook for inflation is deteriorating. Our index of “discretionary” CPI items shows strong inflation over the last three quarters (see chart). This Index captures the impact of margin widening on the CPI. It is our best estimate of the effect of demand on inflation. In annual terms it’s running at its fastest pace since 2001. Evidence of demand pressures on inflation and a rapidly closing labour gap should be enough to see the Bank take another small step to closing the gap with neutral. We retain our view that once neutral has been reached an extended pause would be possible.
Source Westpac Bill Evans, Chief Economist