Glenn Baker, Chief Financial Officer
The Reserve Bank maintained a stable interest rate environment when it left the official cash rate unchanged at 4.75% per annum following it’s July Board meeting, with no change made since November last year.
For some time now expectations have been built up for the resumption of policy tightening in the second half of 2011. Predictions mainly focused on a lift of 0.25% per annum in August, immediately following the release of the June quarter inflation data in late July, with one additional increase of the same size before the end of the year. With August now almost here there are signs emerging that the policy pause may be extended. The shift in thinking is being driven by both global and domestic factors.
On the global front we have seen the re-emergence of concerns about European sovereign and bank debt with particular focus on the problems in Greece and Portugal. This has once again created instability in financial markets and increased the level of caution exercised by investors, businesses and consumers here and abroad. Whilst there have been signs that the European and US economies are improving their level of economic activity, the data has been inconsistent and the growth evolution somewhat unconvincing. In particular, these major economies continue to struggle with very high levels of unemployment. Interest rate settings in Europe and the US are likely to remain low for some time (albeit that the European Central Bank has talked about starting to move rates up) in order to stimulate demand in those economies. This diminishes the potential for there to be any pressure on Australian interest rate settings and supports the Australian dollar.
Domestically, the central theme of a shift toward stronger growth and rising interest rates remains in tact but there are signs that growth forecasts need to be trimmed and the timing of interest rate moves need to be adjusted. The global recovery picture is taking longer to develop and this is not adding to future demand expectations, especially given the negative effect on confidence of repeated episodes of financial market disruption. China continues to underpin the mining and commodity export boom in Australia, with high commodity prices continuing to generate very strong terms of trade. National income is being bolstered significantly as a result.
Other sectors, of the economy are flat by comparison. The combination of a depressed global outlook, cost of living pressures, especially with respect to energy costs, plus uncertainty relating to the impact of the Government’s move to price carbon dioxide emissions are driving a weakening of consumer and business confidence which shows up particularly in soft consumer spending and weak housing sector activity. Additionally, the strength of our dollar is limiting tourism and generating strong import competition for local businesses. On top of this, the recovery from floods and other natural disasters that negatively impacted activity in the early part of 2011 is taking longer than originally expected. Employment growth has been strong in the early part of the year but more recently has slowed to a modest pace.
The growth outlook for Australia remains very positive but the combination of factors discussed above is taking the edge off activity. The strength of the resources sector appears to be offset by the flatness of many other parts of the economy. Whilst ultimately there is expected to be a solid upswing in economic growth this move is being restrained at present.
Inflation continues to be the dominant consideration for the Reserve Bank when it comes to interest rate policy setting. The current circumstances are also moderating the build up of inflationary pressures in the economy. In its latest statement the Reserve Bank itself has softened its line on the upward shift in inflation expectations. Underlying inflation, the measure preferred by the Reserve Bank (as opposed to headline CPI), is forecast to now develop gradually from the low end of the target band, whereas previously it was thought to be heading toward the upper end of the band over coming quarters. This shift in Reserve Bank thinking aligns with evidence of slower than expected (or delayed) economic growth. The next inflation numbers due out in late July will remain critical to the unfolding scenario of rising interest rates. They are not expected to show cause for action but rather to confirm a more benign environment in the short term.
Reflecting on past changes it must be remembered that the Reserve Bank moved quickly to ‘normalise’ interest rates once the stimulation put in place to combat the global financial crisis was no longer needed. Having already made this adjustment future interest rate adjustments carry less urgency. With the raft of current signals pointing toward a more docile environment the Reserve Bank can comfortably hold off any action preferring a more cautious approach until the need to act is made clearer through stronger data.
There is little risk at present to ‘falling behind the curve’. Accordingly, it is unlikely that the Reserve Bank will act to raise interest rates in the short term. There is, however, still an underlying case for eventual tightening of monetary policy through further increases in the official cash rate. This may now need to await the passage of some months or potentially not until we move into 2012.