Glenn Baker, Chief Financial Officer
ING DIRECT

The Reserve Bank Board once again kept the official cash rate steady at 4.75% following its June meeting. The official cash rate has now stayed at this level for seven months.

For some time now there has been a general consensus in the market that interest rates would be kept steady in the first half of 2011 and that over the later part of the year there would be a need to increase them. Now that we have arrived in the middle of the year with that viewpoint proving correct, the focus turns to whether rates will indeed move up over the balance of the year and into 2012.

Inflation, a key driver of monetary policy, has been benign for some time. In fact, the level of underlying inflation at the end of 2010 had fallen to the lower end of the Reserve Bank’s target range. In the first few months of 2011 economic activity was negatively impacted by the severe floods in Queensland and other natural disasters. This translated into negative growth in the first quarter. Aside from the impact of these events, some sectors of the economy, principally consumer spending and housing have been soft for some time. In this climate interest rates were left stable in order to provide support for a weak economy suffering from severe disruptions.

Looking forward evidence is starting to build that not only will the economy move into a stronger growth phase but that inflationary pressures will build that will need to be contained through a lift in interest rates. Australia continues to benefit from historically strong terms of trade as a result of record commodity prices. Exports of hard commodities such as iron ore and coal have been stimulated by demand, particularly from China which continues to produce very strong growth rates. National income has risen strongly as a result of the strong demand and high prices. In turn, investment in resources has been significant and continues to be the dominant element in the performance of the economy. This investment is creating greater demand for skilled labour in an employment market that is already experiencing low levels of unemployment. As economic activity builds and conditions generally improve and rebuilding takes place in the areas adversely affected by the earlier natural disasters further pressure will be placed on the labour market. Improved levels of wages growth have been evidenced in recent months and this is likely to feed into a more general lift in prices over time.

The latest reading on inflation for the March quarter showed a significant upward spike. This, however, was largely the result of supply shocks arising from the floods and other events that dramatically raised the prices of some commodities and produce. Accordingly, this can be discounted as a one-off event and not indicative of the true underlying price developments in the same way that the disruption to economic growth was only a short term impact. The underlying inflation measure does appear to have started to rise from its low point. Price increases for utilities, in particular, have been progressively increasing. The upward trend in underlying inflation is expected to continue over time influenced by stronger growth and tight labour market conditions.
The Reserve bank itself is now forecasting that underlying inflation will move toward the top of its target range over the balance of 2011. It is this potential development that is behind the need to raise interest rates at some time over coming months.

More recently we have seen world economic growth expectations soften, particularly for the developed economies of Europe and the U.S. This can potentially have a moderating effect on global demand which could have a flow on effect on Australia even if only through sentiment and the negative wealth effects generated by falling equity markets. This is not expected to have a significant impact with Australia’s fortunes very much linked with China these days. There is some prospect though that slower world growth, weaker sentiment and disruption to markets could limit the pace of change in Australia. To that end there could be a slower increase in inflation with increase in interest rates delayed.

For the reasons outlined it remains highly likely that the Reserve Bank will raise the official cash in coming months. The decision to act will be closely linked to the pace of change in the inflation rate. The release of the June quarter figures in late July will be an important guide. In the event that inflation is moving up quickly the Reserve Bank could lift the official cash rate as early as August. If that is not the case the change may come in the latter part of the year. By the end of the year, though, the official cash rate is expected to be 0.25% higher at 5.0%.