The Experts

The Reserve Bank left the official cash rate unchanged at 4.5 per cent per annum for the third month in a row following its 3 August meeting.

The decision was made after the release of tame second quarter inflation data on 28 July. This information had been seen as a critical component of the Reserve Bank’s decision-making.

In the lead up to the latest meeting, there had been considerable speculation in the market as to, firstly, what the inflation readings would look like and, secondly, what the Reserve Bank would do in response to the actual inflation numbers.

As the release of the inflation data drew near, there was a gathering view that inflation would remain uncomfortably high and that the Reserve Bank would need to act to contain it. Market opinion surrounded a rise of 0.8 per cent to 0.9 per cent for underlying inflation for the quarter, which would have kept the annual underlying inflation rate above the target ceiling of three per cent. As it eventuated, the rise in underlying measures for the quarter was only 0.5 per cent and the annual change in underlying inflation came in at 2.7 per cent.

In its previous month’s commentary, the Reserve Bank indicated that one of the factors influencing its ‘no change’ decision was the fallout from the latest developments in the European debt crisis, which arose in May and persisted into July. The Reserve Bank wanted to see these concerns, which had the potential to dampen global growth and in turn soften the positive external influence on Australia, subside before moving to further dampen local demand through higher interest rates.

The recent stress tests conducted on European banks by the European Central Bank were seen as an important indicator with respect to the European debt scenario. As it eventuated, these tests showed that the majority (nearly all) of 91 European banks tested had a strong capital position and could withstand further market stresses and maintain the required level of capital. This positive news, on top of the inflation expectations, added to the market perception that the Reserve Bank might increase the official cash rate at the August meeting as one of the factors suggesting a cautious approach had been significantly diminished.

Going forward, there remains the likelihood that, at some time in the future, interest rates will need to be increased further. Forecasts for the Australia’s economic growth remain strong and the government has recently revised upward the revenue improvements that will flow from the high terms of trade and the export boom that continues to be fuelled by China’s significant growth and demand for our raw materials, particularly coal and iron ore.

The timeframe for further monetary policy tightening, however, remains clouded. Inflation seems under control for now but is forecast to increase over the course of 2011. Global growth is building slowly but is temporarily obstructed by both the European debt concerns and the lack of job creation in the US (evidence of the shallowness of the recovery taking place there).

As 2011 unfolds, the global economic picture should strengthen and this will add fuel to the local inflation outlook as growth generally, and mining sector growth in particular, expose capacity constraints, in turn putting pressure on wages and prices.

Australia’s labour markets have remained strong throughout the economic downturn and, while unemployment rose, it did not reach anything like the levels forecast and has fallen quickly to be back around – and potentially ready to go below – five per cent. Any lift in economic growth from a stronger world scenario will undoubtedly put pressure on labour markets and it is hard to see this not feeding into wages costs and ultimately inflation more generally.

In the short-term, there are also some indications that the tightened monetary policy to date has had a softening effect on domestic demand. While this may not remain the case, it is also a sobering factor for Reserve Bank consideration over the balance of 2010. Areas of the economy that have slowed as a result of interest rate increases include housing finance and home sales – of which have also seen house price growth slow, building approvals and consumer spending.

Given the current acceptable inflation readings and pockets of softness in the economy, it is most likely that the Reserve Bank will leave interest rates on hold until its November meeting, just after another quarterly reading on inflation in late October. In the longer term, however, it is still expected that improving global growth, and the positive effect this will have on Australia, will lead to higher interest rates over the course of 2011.

Australian households seem to be conscious of the need to contain debt to soften the potential impact of higher interest rates. A key finding of the ING Direct Financial Wellbeing Index for 2010’s second quarter is that households are acting to reduce debt. This is both for short-term debt such as credit cards and longer-term debt like mortgages. The research found that households are placing a priority on debt reduction.

The median credit card balance fell from $1802 in quarter one to $1673 in quarter two. The median mortgage balance in quarter two was $175,509, down from $177,259 in quarter one, despite house prices and average loan sizes continuing to increase over that period.

The ING Direct Wellbeing Index measures the level of household comfort across a range of aspects of household finances such as debt levels, income, savings, investments and ability to meet household bills. The latest results show that while households remain generally comfortable with their level of debt they are taking action to reduce it. This action will help cushion the effect of rising interest rates.

Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

As widely, almost universally, expected, the RBA again left the official cash rate unchanged at 4.5 per cent at its 6 July meeting.

The events of the past couple of months have led to a significant shift in opinion about the expected course of monetary policy over the balance of 2010 and beyond. Only a few months back, there was still an expectation that, although the RBA had effectively engineered lending rates to be close to normal levels, ongoing solid economic growth combined with stubbornly high inflation readings would lead to further monetary policy tightening of the order of 0.5 per cent before the end of 2010. This would have taken the official cash rate to five per cent per annum.

The view beyond that was, under the weight of mining boom-induced growth rates, the RBA would need to enter into a restrictive phase for monetary policy and move the cash rate toward six per cent during 2011. All this was subject to there being a measure of ongoing stability, if not positive signs, in global markets.

Well, global markets have been anything but stable. Concerns about European debt levels reemerged during May and have generally dominated market thinking, resulting in significant equity market falls. Pledges by the G20 countries to stabilise and then reduce debt levels only served to add to the weak global growth picture with there being a further deterioration in confidence and a further flight to safety. Risk aversion has been the predominant theme in markets and this has produced major downturns in equities and a reticence to buy debt securities, which has again frustrated the ability of banks to borrow to fund lending.

This market instability and the negative flow on effect on confidence mean that the outlook for world growth remains subdued. Even the robust economic performance in China and Asia is generally anticipated to ease. Central banks, including the RBA, will be cautious in the application of monetary policy in such an environment. They will want to ensure interest rates remain accommodative of growth.

So not only did the RBA leave the official cash rate on hold this month but there is a high likelihood that it will continue to leave monetary policy settings steady until there are clear signs that the global economy is regaining some positive growth momentum.

While locally there continues to be talk about our stubbornly high inflation readings and the need to subdue them, there have been domestic indicators that are suggesting that past interest rate increases are having a depressing effect on growth. These include:

• Sluggish retail sales
• Slower housing finance growth
  
• Lower building approvals
  
• Lower auction clearance rates
  
• A pullback in consumer confidence
  

These factors also give the RBA reason to hold off on any further interest rate increases in coming months until there is greater surety that the economy is not slowing down.

An interesting feature of the current market is the effect global economic weakness has had on longer-term interest rates across the developed world. The concern about world growth has pushed these longer rates down including Australian government bond and interest rate swap rates – the latter being a major factor in determining fixed-term funding costs for banks and therefore the level of fixed interest rates they offer for home loans.

The differential between fixed rates and variable rates is narrowing due to the cash rate remaining steady while swap rates fall. Since the official cash rate was raised from 4.25 per cent to 4.5 per cent in early May, the five-year swap rate, for example, has fallen from around 5.9 per cent to 5.3 per cent. While this shift has not yet been fully reflected in five-year fixed mortgage rates, these rates are in decline.

With longer-term expectations remaining that once the present difficult global environment passes Australian interest rates will again need to move higher, these lower levels of term interest rates may offer effective protection against future potential rate rises. The reducing differential to borrow fixed is lowering the cost of insurance in uncertain times and borrowers that can be severely affected by large future interest rate increases should seriously consider this option.

Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

The RBA increased the official cash rate again today by 0.25 per cent p.a, taking it to 4.5 per cent p.a. This is the third increase in as many months and the sixth rise since policy tightening began in September last year. The cash rate has now been raised by 1.5 per cent p.a. following its low of three per cent p.a.

For some time now discussion around monetary policy has centred on the declared position of the RBA to remove ‘emergency’ rate settings and to take interest rates back to a neutral or normal level. The RBA has in recent times made it clear that it is focusing on lending rates (which due to cost of funds pressures have been increased by banks over and above the size of official cash rate increases) and that we are now getting close to a level that could be considered normal. There is still some conjecture in the market as to when the monetary policy setting will actually be considered neutral but all indications are that we are quite close, possibly within 0.25 per cent p.a. or 0.5 per cent p.a. of that point.

The question arising now is where will interest rates go in the longer term?

There are a number of factors arising that suggest that the RBA may have to eventually go beyond the neutral level. The Australian economy is continuing to perform strongly with 2009 GDP growth coming in at 2.9 per cent, and forecasts are being upgraded for growth over coming quarters. Expectations are now that the economy will grow at a rate of between three per cent and 3.5 per cent.

The global economy is recovering and confidence is high in the future. Whilst interest rate increases to date appear to have acted to slow some sectors such as retail sales and housing finance there is a generally high level of expectation that Australia will experience healthy levels of activity into the future. Much of the confidence is being driven by the strength of the Asian region and China in particular which is driving significant increases in commodity prices.

As a result Australia’s terms of trade are undergoing another significant boost and this will generate strong growth in national income through the increased export revenue, especially from coal and iron ore.

The labour market has been extremely robust and unemployment has fallen significantly over the past year, as opposed to the increase that was originally feared as a consequence of the global financial crisis. Given the general expectations for the economy, employment is forecast to continue to keep growing and there is likely to be capacity constraints and skill shortages in the booming resources sector. Subsequently we could see the emergence of some wage pressures as companies bid up the price of skilled workers.

With the latest inflation data indicating that inflation is not abating as quickly as expected but remaining at the top of the RBA target range of two per cent to three per cent, there is the prospect that further monetary policy tightening will be required to stave off an unhealthy development on that front.

In recent months the RBA has also made references to rising house prices and the need to avoid a bubble developing which could later threaten stability. The latest data continues to show that house prices are growing at a very healthy rate. They were up by almost five per cent in the first quarter of 2010 and have risen around 20 per cent from a year ago. These price moves are being driven by fundamental supply and demand factors. There are simply not enough houses being built to meet the demand. With immigration numbers climbing to record levels this trend is not expected to abate any time soon and the RBA may need to use tighter monetary policy as a tool to cool the market.

On the other hand, we have seen some signs that recent interest rates rises have had some bearing on consumer sentiment and spending. This has only been modest so far and will certainly be an area to watch in future. Confidence in the economy is generally high and the resources boom is likely to continue to drive this.

All things considered, there is a case building for the RBA to need to move from simply removing ‘easy’ interest rate settings into a restrictive phase. This is where it takes interest rates higher in order to ensure the economy does not overheat, leading to inflation concerns and unsustainable house price increases. Over the balance of 2010 the official cash rate will probably be shifted upward to five per cent p.a., a level considered to be at or slightly above a neutral positioning. In 2011 there is a growing prospect that interest rates will need to move beyond this level and toward six per cent p.a.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

The RBA increased the official cash rate again this month by 0.25 per cent pa taking it to 4.25 per cent pa. This represents the fifth increase of 0.25 per cent since the RBA commenced raising the cash rate in September last year.

The RBA has indicated on a number of occasions that the low level of interest rates it created at the beginning of 2009 (by moving the official cash rate down to three per cent pa) was no longer required as the fear of recession had passed. In September the RBA embarked on a process of ‘normalising’ the cash rate. This has been generally interpreted as meaning that the cash rate would move back to around five per cent pa over the balance of 2010. The ‘normal’ level has historically been a little higher than this, say around 5.5 per cent pa to six per cent pa, but the RBA has more recently been focusing on bank lending rates which have moved higher by around another one per cent pa than moves in the official cash rate due to cost of funding pressures experienced in the markets. Taking this into account the RBA is expected to move the official cash rate up to around five per cent pa.

There is little prospect that the RBA will not execute this strategy. The main question still relates to the pace with which the interest rate increases will come. After today’s move there is the prospect that there could be a pause for a month or two. Interest rates are still expected to increase by 0.25 per cent pa another three times over the next eight months.

The Australian economy has been performing exceptionally well and further signs of improvement in the global economy are adding to the impetus behind the Australian economy. Of particular significance is the ongoing rise in commodity prices which continues to boost Australia’s terms of trade and revenue prospects. China continues to post impressive growth numbers and its demand for our raw materials is a major factor driving Australia’s strong export performance. In the US economic growth has improved considerably over the past few quarters, albeit from a very weak starting position, and there is now encouraging news on the employment front with the dramatic job losses over the last two years having abated and job growth starting to emerge on a monthly basis. These factors are leading to improved confidence in the global recovery, which in turn is fuelling commodity price rises and the outlook for Australia.

On the domestic scene, Australia continues to experience strong employment growth. The gloomy forecast of a year ago for an 8.5 per cent unemployment rate seems a distant memory with unemployment peaking at 5.8 per cent in October and falling since then to around 5.3 per cent. Further improvements in employment, which are highly likely, could threaten to push up inflation. There have been some signs that the rate increases to date have had an impact. Consumer confidence has fallen in recent months although it is still holding up at high levels, retail sales have been up and down over recent months with the trend being basically flat for some time and housing finance has also eased back over recent months. The increases in interest rates have occurred following the passing of Government stimulus measures such as cash payments and first home buyer boost. Taken together these things seem to be having a dampening affect on some sectors of the economy.

Despite these indications the RBA has identified another source of concern that is adding to its view that interest rates need to be raised back to more historically normal levels. Australian house prices have been rising strongly over the past year and particularly in very recent months. The expectation is that they will continue to. This is due to a fundamental imbalance between demand and supply. Not enough houses are being built to satisfy the needs of the growing population, especially given the current high immigration numbers. Whilst the RBA is mainly tasked to target monetary policy to ensure low inflation and full employment it has increasingly made reference to the need to avoid a bubble in home prices. The RBA Governor, Glenn Stevens even took this message onto breakfast television recently. This is now clearly part of the monthly deliberations and another reason why the direction of interest rates is clear.

There is little doubt that interest rates are still on an upward path over 2010. The Reserve Bank of Australia (RBA) delivered the latest interest rate increase instalment after its Board meeting on 2 March to take the cash rate up by another 0.25 per cent to four per cent. The RBA has made it quite clear on a number of occasions that the ‘emergency’ interest rate settings during the global financial crisis have done their job and that it wants to move interest rates back to more normal levels. The latest move combined with the three increases of 0.25 per cent in the final months of 2009 has added one per cent to official cash rate so far in this tightening cycle. At the last meeting in February the RBA left the cash rate unchanged. This initially surprised the market and raised some doubts about the RBA’s monetary policy intentions. So what does the future now hold and where will rates end up in 2010?

The RBA indicated after the February meeting that it paused from increasing rates to review the effect of its earlier actions and to evaluate developments in the global economy. Globally there has been a great deal of concern about the debt levels of some countries, with Europe and Greece in particular under scrutiny. The potential for debt default and the longer-term effect of the need to wind back fiscal stimulus has placed a cloud over the rising optimism regarding global growth forecasts. Additionally, recent data coming out of the US. has indicated that economic recovery there is evolving slowly and this too will continue to cause a drag on the global outlook.

Undoubtedly this renewed global uncertainty added to the caution exhibited by the RBA. It was never expected that rates would be adjusted every month but understanding when the RBA would take a break from regular monthly monetary policy tightening was complicated by the strength evidenced in the local economy.

Australia has performed exceptionally well, especially by comparison to the major industrialised nations which have all fallen into recession in recent history. With China growing strongly and having a strong influence on the Asian region, Australia has been a major beneficiary through strong export performance. Additionally, the combination of government stimulus in its many forms and low interest rates has boosted domestic activity.

• A sharp rise in consumer sentiment over recent months and a return to the higher levels that prevailed prior to the global financial crisis
• A strong performance in retail sales which again lifted strongly in January
• Exceptionally strong employment growth with the unemployment rate peaking in late 2009 at 5.8 per cent and falling back to 5.3 per cent in January 2010.

The end of some elements of stimulus had seen moderation in some areas of the economy. For example, the end of cash bonuses and more recently the first home owner boost coupled with the RBA action to raise interest rates had seen the edge come off sentiment resulting in a slowing in retail sales in December and reduced housing finance approvals. The softer data probably added to the RBA’s decision to pause in February. More recent readings on the economy indicate further strengthening and accordingly, the RBA has resumed its action to raise interest rates.

In the longer run, the RBA is committed to moving interest rates up to typically normal levels. Historically normal levels have seen the official cash rate at approximately five to six per cent. Now, however, the RBA is more focussed on the rates borrowers pay. Given that banks have generally increased lending rates over time by more than the official rate movement, the neutral level for the cash rate is seen as being lower. It looks like the cash rate will probably be increased to around 4.75 per cent by the end of 2010. This will place standard variable home loan rates at 7.5 per cent to 7.75 per cent. A move up to these levels will only necessitate adjustments to the official cash rate of 0.75 per cent over the balance of 2010. The RBA is therefore likely to leave rates on hold for about six of the nine monthly meetings remaining this year, adding 0.25 per cent at each of the other meetings. An orderly progression would suggest increases every three months from now.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

The scramble for funding around the globe is continuing to put pressure on the cost of money and the Reserve Bank in Australia looks likely to continue increase the cash rate back to a more neutral setting, around five per cent.

On the upside, Australians will continue to secure high rates for their savings as banks compete for local funds.

The tightening of monetary policy with likely see progressive 0.25 per cent moves of the cash rate until it reaches around fiver per cent by the end of 2010.

Last year, the Australian economy put in a remarkable performance by defying recession and producing better growth than any of the major industrialised nations.

The Global Financial Crisis had been expected to have a heavier impact than it did.

Government spending and record low interest rates acted to cushion the effect of a global economic downturn and kept the Australian economy on track.

As the performance of the economy improved, both business and consumer confidence recovered. This in turn had a positive effect on investment and spending.

This year rising interest rates will temper the recovery. The increasing interest rates will also put pressure on personal savings. The latest ING DIRECT saving census has revealed almost one in five Australian’s (18 per cent) have less than $1000 in the bank.

Other results show 40 per cent of males have $5000 or more in the bank, while almost 20 of females don’t know how much they have in the bank. The Saving Census also found over a quarter of those who earn under $40,000 are pessimistic about the future whilst only 10 per cent of those who earn over $70,000 are pessimistic.

In an attempt to keep debt under wraps, Australian families are turning to cash and the use of debit cards. The Savings Census revealed more than a quarter of Australians will spend less on credit cards in 2010 and only six per cent have said they will spend more on credit cards in 2010.

The results of this census show the downturn has affected people in different ways; 2010 is going to be a real test for Australians and how they mange their money.

For some households the money is running out with four in ten (40 per cent) Australians saving less than they were five months ago or not saving any money at all (21 per cent).

This is particularly so for low income families where 56 per cent are saving less or not at all (33 per cent).

With the current cash rate at 3.75 per cent, a move up to five per cent will flow through to higher mortgage and savings rates, putting pressure on many Australian families.