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Cash rate steady for fifth month

Glenn Baker - Rates expert
Friday, October 15, 2010

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The October decision by the RBA to hold the official cash rate steady for the fifth month in a row at 4.5 per cent extends the pause in a rising rate cycle.

Most market economists and commentators had anticipated an increase this month, their views being influenced by recent comments by RBA Governor Glenn Stevens which suggested that higher interest rates could be expected at some point in the future due to the strong economic growth being experienced in Australia. The September RBA meeting minutes also reinforced this expectation.

Some analysts remained of the view that the RBA would take a wait and see approach, with third quarter inflation data being released later this month, before recommencing their tightening cycle. This data now becomes critical to the next assessment of monetary policy at the November RBA meeting.

In announcing the latest decision, the RBA again made reference to uncertainty in financial markets and strained conditions in some countries in Europe. The global setting is still providing a cautionary backdrop to the RBA decision process.

Despite some softer domestic economic data over the last week, including easing house prices and lower than expected results for building approvals and retail sales, the RBA expects the Australian economy to continue growing at around trend, with an increasing contribution to come from the private sector, as it benefits from increasing strength in the terms of trade. This rising private sector demand will offset the reduction in fiscal stimulus that is occurring as the measures taken by the government during the financial crisis either end or diminish over time.

Unemployment is currently sitting at 5.1 per cent having resumed its fall in recent months and jobs growth remains strong. The strong labour market is indicative of a strong economy. Further strong growth may, however, lead to capacity constraints in some sectors which may, in turn, give rise to wage pressures and feed into higher inflation down the track.

China has continued to produce strong growth and their demand for our commodities (iron ore and coal) is a significant driver of exports and economic growth in our economy. It is this, combined with high commodity prices, that is providing a significant boost to national income.

Australia has for some time been benefitting from the strength of the Asian region, led by China, and this has insulated our economy from the concerns evident in Europe and the US. In any event, concerns about further deterioration in the European and US economies have not materialised at this point but the RBA expects growth in these economies to be modest in the near-term. Some encouraging data out of the US over the last week, including economic growth numbers which came in above expectations and improvements in personal consumption and jobless claims, have helped ease fears of a flagging recovery and possible double dip recession.

Looking ahead, the RBA has clearly signalled that it expects higher interest rates will be required in the future. The market is still pricing in the chance (albeit reduced) of an increase before Christmas. The RBA's October decision has given market participants reason to pause and reevaluate monetary policy expectations.

While the RBA has indicated its view on the direction of interest rates, it has said nothing (and won't) about timing. The factors influencing its decision process continue to be, on the one hand, the state of the global economy and markets which have been undergoing difficult and volatile times and on the other hand the strength of the local economy and the outlook for inflation. The RBA has been balancing these factors in recent months in favour of a 'steady as she goes' approach to interest rates.

It is highly evident that the balance is shifting and that the RBA is close to commencing the next phase of monetary policy tightening. It should be remembered that the interest rate rises seen in the latter part of 2009 and the early part of 2010 were designed to remove 'emergency settings' designed to offset the impact of the financial crisis. The next phase will be embarked upon to restrict excessive growth, which could lead to imbalances in the economy and the emergence unhealthy rates of inflation.

The RBA will also want to ensure that it does not start this restrictive phase too soon as this could derail the healthy growth developing in the private sector, especially in interest rate sensitive sectors such as housing and retail sales. As indicated, the third quarter inflation data holds the key to interest rate considerations in the short term.

Given that inflation is sitting at the top of the RBA target band, it will probably require a fall in the inflation readings to keep the RBA from raising rates at the November meeting. One proviso would be that there are no new shocks to the global economy, which obviously still remains a factor in the RBA assessment.

Regardless of whether the RBA moves in November or not there is a very high likelihood that the monetary tightening cycle will recommence within the next few months and that it will continue well into 2011. Increases in the official cash rate of around one per cent are likely over the next twelve months as the local economy moves into above-trend growth and the global economy further stabilises and global economic growth improves.

What does the hold on interest rates mean for your investments? Commsec's Craig James explains.

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.

Published: Friday, October 15, 2010


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