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Reserve Bank acknowledges pain in community

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The Reserve Bank Board has left official rates at 4.25 per cent. Last year, the Reserve Bank cut rates at both the November and December meetings, each by 25 basis points. The next meeting is on 3 April 2012.

The Reserve Bank acknowledges the pain occurring in some sections of the community with “structural change” mentioned twice in the statement.

What does it all mean?

The Reserve Bank Governor is in that “happy place”. Inflation is in the middle of the two to three per cent target band; economic growth is expected to be close to “trend” over the next year; and the European debt crisis is a “watching brief” rather than a major issue. In short, there are no pressing reasons to cut interest rates and there are no pressing reasons to lift rates. And the Reserve Bank would require a significant shove to move from its current stance.

Still, if rates are likely to move anywhere in coming months, the risk is clearly on the downside. Manufacturing, services and construction sectors are contracting; the high Aussie dollar is still troubling businesses; inflation is well contained; and interest rate settings are on the high side of “normal”. We have penciled in a rate cut in May – after the next batch of inflation figures in late April.

The Reserve Bank has paid lip service to the pain being felt in many parts of Australia, noting “considerable structural change”. Presumably the Bank believes the best it can do in the current environment is leave rates steady and let the forces of change work their magic.

Some economists believe that there is no ‘two speed’ economy, or if there is, the differences between industries and regions aren’t much different than the past. Most would disagree. Domestic-focused businesses continue to struggle – and not just in areas like manufacturing, construction and tourism. The Australian services sector continues to go backwards and has underperformed its US counterpart for the past two years. Looking at a chart of the services indexes of the two countries, an observer would rightly ask which economy is supposed to be struggling.

The Reserve Bank Governor would closely watch bank-funding costs. If there was pressure on banks to lift rates again, the Reserve Bank would be concerned about the implications for economic growth and would preemptively trim cash rates.

Certainly the Reserve Bank will also closely watch Chinese monetary policy decisions following the recent downward revision to the economic growth forecast for 2012. The decision probably is more a strategic decision to manage expectations rather than being a true forecast. But if the Chinese economy were to slow, then the Reserve Bank would have no hesitation about cutting interest rates to stimulate consumer spending and housing investment.

Interest rate decision and past cycles

The Reserve Bank Board has left the cash rate at 4.25 per cent for the second month after previously electing to cut rates at both the November and December meetings, each by 25 basis points. (The Reserve Bank Board doesn’t meet in January). The Reserve Bank had previously lifted rates seven times from October 2009 to November 2010 – a total of 1.75 percentage points, from three per cent to 4.75 per cent.

In the last rate-cutting cycle, the cash rate fell to a low of three per cent in April 2009. In the previous rate-cutting cycle the cash rate fell to 4.25 percent in December 2001. In the two previous rate-cutting cycles, the cash rate fell to lows of 4.75 per cent.

The Reserve Bank now looks more closely at the variable housing rate to gauge how close rates are to “normal”. Currently, the average bank variable housing rate stands at 7.4 per cent, broadly in line with the long-term average or “normal” rate of 7.2 per cent.

What are the implications of today’s decision?

No surprises this month. Last month most economists tipped a rate cut and were caught out. Why were all the so-called “experts” wrong? The missing ingredient was Reserve Bank views on last year’s rate cuts. Economists weren’t aware that the Reserve Bank thought there would be only partial pass-through of the late 2011 rate cuts. Clearly when it came to the February Board meeting, members thought there were already enough stimuli being applied to the economy.

If interest rates are left unchanged for a few months and global financial markets continue to settle then businesses and consumers will have more confidence to spend, borrow, invest and employ. We expect that home building will lift over 2012 in response to tight rental vacancy rates, low interest rates, a firmer job market and rising migration.

Savers remain in the ascendancy. Currently banks are offering 5.4 per cent on a 90-day term deposit at a time when the cash rate stands at 4.25 per cent and the three-year swap rate stands near 4.4 per cent.

CommSec continues to expect one further rate cut from the Reserve Bank. At this stage, we are factoring in a move in May, after the next inflation figures. But clearly the timing could be brought forward if the European debt crisis was to turn ugly.

The Aussie dollar is on the Reserve Bank’s radar screen. If commodity prices fall but the Aussie doesn’t budge then this would represent a tightening of conditions, possibly prompting a Reserve Bank rate cut.

Comparing the two most recent statements

The statement from the February meeting is first; the statement from today’s March 2012 meeting is second. Emphasis has been added to significant changes in wording in the recent statement.

Statement by Glenn Stevens, Governor Monetary Policy

Date: 7 February 2012

At its meeting today, the Board decided to leave the cash rate unchanged at 4.25 per cent.

Information becoming available since the December meeting confirms that economic conditions in Europe were weakening late last year, with risks still skewed to the downside. Reflecting this, most forecasters have lowered their forecasts for world GDP growth this year to a below trend pace. That said, recent data from the United States suggest a continuing moderate expansion after a soft patch in mid 2011. Growth in China has moderated as was intended, but on most indicators remained quite robust through the second half of last year. Conditions around other parts of Asia have softened. Commodity prices declined for some months to be noticeably off their peaks, but over the past couple of months have risen somewhat and remain at quite high levels.

The acute financial pressures on banks in Europe were alleviated considerably late in 2011 by the actions of policymakers. Much remains to be done to put European sovereigns and banks on a sound footing, but some

progress has been made. Financial market sentiment, though remaining skittish, has generally improved since early December. Share markets have risen and term funding markets have re-opened, including for Australian banks, albeit at increased cost compared with the situation prevailing in mid 2011.

Information on the Australian economy continues to suggest growth close to trend, with differences between sectors. Labour market conditions softened during 2011 and the unemployment rate increased slightly in midyear, though it has been steady over recent months. CPI inflation has declined as expected, as the large rises in food prices resulting from the floods a year ago have been unwinding. Year-ended CPI inflation will fall further over the next quarter or two. In underlying terms, inflation is around 2.5 per cent. Over the coming one to two years, and abstracting from the effects of the carbon price, the Bank expects inflation to be in the two to three per cent range.

Credit growth remains modest, though there has been a slight increase in demand for credit by businesses. Housing prices showed some sign of stabilising at the end of 2011, after having declined for most of the year. The exchange rate has risen further, even though the terms of trade have started to decline. This is largely a reflection of a decline in the euro against all currencies. Nonetheless, the Australian dollar in trade-weighted terms is somewhat higher than the Bank had previously assumed.

At today's meeting, the Board noted that interest rates for borrowers have declined to be close to their medium-term average, as a result of the actions at the Board's previous two meetings. With growth expected to be close to trend and inflation close to target, the Board judged that the setting of monetary policy was appropriate for the moment. Should demand conditions weaken materially, the inflation outlook would provide scope for easier monetary policy. The Board will continue to monitor information on economic and financial conditions and adjust the cash rate as necessary to foster sustainable growth and low inflation.

Statement by Glenn Stevens, Governor Monetary Policy

Date: 6 March 2012

At its meeting today, the Board decided to leave the cash rate unchanged at 4.25 per cent.

Recent information is consistent with the expectation that the world economy will grow at a below-trend pace this year, but does not suggest that a deep downturn is occurring. Several European countries will record very weak outcomes, but the US economy is continuing a moderate expansion. Growth in China has moderated as was intended, but on most indicators remains quite robust overall. Conditions around other parts of Asia softened in 2011, partly due to natural disasters, but are not showing signs of further deterioration. Some moderation in inflation has allowed policymakers in the region to ease monetary policies somewhat. Commodity prices declined for some months and are noticeably off their peaks, but over the past couple of months have risen somewhat and remain at quite high levels.

The acute financial pressures on banks in Europe have been alleviated considerably by the actions of policymakers, though there is more to do to put European banks and sovereigns onto a sound footing for the longer term and Europe will remain a potential source of shocks for some time yet. Financial market sentiment has continued to improve in recent weeks and capital markets are again supplying funding to corporations and well-rated banks, albeit at costs that are higher, relative to benchmark rates, than in mid 2011.

Most information on the Australian economy continues to suggest growth close to trend overall, with differences between sectors and considerable structural change. Labour market conditions softened during 2011 and the unemployment rate increased slightly in midyear, though it has been steady over recent months. CPI inflation has declined as expected and will fall further over the next quarter or two. In underlying terms, inflation is around 2.5 per cent. Over the coming one to two years, and abstracting from the effects of the carbon price, the Bank expects inflation to be in the two to three per cent range. This forecast embodies an expectation that productivity growth will improve somewhat as a result of the structural change occurring in the economy.

Interest rates for borrowers have generally risen slightly since the Board's previous meeting, but remain close to their medium-term average. Credit growth remains modest. Housing prices have shown some sign of stabilising recently, after having declined for most of 2011, but generally the housing market remains soft. The exchange rate has risen over recent months, even though the terms of trade have declined.

With growth expected to be close to trend and inflation close to target, the Board judged that the setting of monetary policy remained appropriate for the moment. Should demand conditions weaken materially, the inflation outlook would provide scope for easier monetary policy. The Board will continue to monitor information on economic and financial conditions and adjust the cash rate as necessary to foster sustainable growth and low inflation.

Published on: Wednesday, March 07, 2012

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