Michael Witts, Treasurer
ING DIRECT

At its meeting on Tuesday, the Reserve Bank of Australia left the cash rate unchanged at 4.75%. The cash rate was last adjusted (an increase of 25 bp) in November 2011.

The Bank cited increased global uncertainty, especially in Europe and the US, to support the case for rates to remain on hold. In contrast to recent meetings, where the RBA placed heavy emphasis on the resources and related sectors, the Bank appears to have placed greater importance on the slower sectors in the two speed Australian economy.

The Bank further noted that the domestic economy was underperforming, compared to expectations, particularly; consumer spending and sentiment is in the doldrums. Major department stores and restaurants have been most affected by the reluctance of consumers to spend.

Consumers are being told Australia is experiencing a once in a generation boost to income, yet at a personal level they are yet to see the benefits flow through. Equally, the weakness in housing prices conveys a negative wealth effect to consumers.

The Bank also noted that the strong AUD is impacting import competing industries. These domestic manufacturing industries are very exposed to the high value of the Australian dollar as it makes imports cheaper and erodes their margins and market share. Although those sectors related to resources are enjoying current market conditions, the balance of industries are suffering from the combination of weak domestic demand and cheaper imports.

The Bank had expected the recovery in production in flood affected sectors (especially coal) to be faster than has occurred. Delays in the rebuilding of essential public infrastructures and mine specific works have contributed to these delays.

Against the background of a generally weak domestic economy, the RBA Board re-iterated its concern about the medium term inflation outlook, however, judged that the current setting of monetary policy was delivering the appropriate level of restraint. Reflecting the subdued level of activity in most sectors of the economy, credit growth has slowed. In addition, various sectors of the economy, especially the household sector are rebuilding their balance sheets, as clearly evidenced through the higher savings ratio. The combination of these factors is reflected in asset price growth being constrained.

These factors provided the RBA with some breathing space to leave rates on hold while also providing time for international markets to become more settled after the events of the past three months.

Despite the absence of a change in rates at Tuesday’s meeting, the Reserve Bank remains concerned about the medium term outlook for inflation.

The comments from Tuesday’s meeting suggest the RBA will hold rates over the balance of this year, and potentially into the first quarter of next year.

Despite inflation being at the upper end of the RBA’s preferred (or target range), and expected to move higher, the Bank indicated that past interest rate increases and the knock on effect to the exchange rate, were effectively doing some of the work for the Bank.

This will provide welcome relief to borrowers across the economy, especially in the household sector.

The RBA will be on hold until, in its mind, stability has returned to the global economy especially Europe and the US; or the feared domestic inflation outcome and trajectory reach levels that are outside the RBA’s comfort zone.

Improved stability in offshore markets will contribute to enhanced consumer confidence which in turn should gradually see improved retail sales.

Australian consumers appear not to appreciate the current out performance of the economy on a global scale. Events in Europe and the US hold disproportionate sway over sentiment in the domestic economy. China and Asian economies including India are the economies that drive the prospects for the domestic economy.

The next reading of the overall economy will be available in early September with the release of the June quarter economic growth numbers. These are expected to show that although there has been some recovery from the weather events in the first quarter the process is more drawn out than previously expected. Consumer spending is expected to be weak, although investment spending is likely to have accelerated. The Savings ratio will have remained at or near recent strong levels.

Ahead of the growth numbers, the RBA will, at the end of this week, publish its quarterly Statement on Monetary Policy which will provide an update of the Bank’s inflation and growth forecasts. This may likely introduce further volatility into financial markets, as the RBA could suggest inflation, and hence rates environment, higher than is currently reflected in market interest rates.