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Economic Update – September 2011

Published on 08/09/2011

Michael Witts, Treasurer

Extreme volatility has characterised global financial markets over the past month. The combination of the ongoing European Sovereign Debt crisis and the stand off and last minute resolution of the US budget deficit issue, which culminated in the down grading of US government’s credit rating, contributed to the extreme volatility.

Domestic markets have lurched from anticipating significant rate cuts, to a more balanced view of near term interest rate movements.

The balanced view was endorsed by the release of minutes from yesterday’s RBA meeting, which resulted in the cash rate being left at 4.75%.

The accompanying statement highlights the dilemma facing the Bank.

Despite the Board remaining “concerned about the medium term outlook for inflation, the uncertainty and financial market volatility has reduced business and consumer confidence which may result in more cautious behaviour of firms and households. The key question for the Board is the extent to which softer global and domestic growth will work, in due course, to contain inflation.”

The RBA does not suggest that they see reasons for a near term easing in interest rates. 

Rather, the Bank suggests that a slowing in the economy, due largely to offshore events and the high level of the Australian dollar, will contribute to less inflationary pressures, thereby avoiding the need for interest rate increases.

This supports the argument for the cash rate to remain on hold for an extended period.

The question for policy makers will be judging the extent to which the recent financial markets volatility has impacted consumer and business confidence.

The impact will be reflected in retail sales and other measures of consumer spending over coming months.

Employment data will be a key indicator to assess the impact on the business outlook. Data on these indicators will be released over the next few months.

It is likely the RBA will be on hold until it has got a clearer read on the direction of the economy. This could be well into 2012.

The RBA is reluctant to ease prematurely, given the inflation risks, together with the strong performance of the resources and related sectors.

Key local measures of consumer and business confidence will be followed very closely over coming months.

International developments continue to have the capacity to derail the domestic economic outlook.

Progress on resolving the European issues have been painfully slow and largely ineffective over the northern summer. European leaders need to demonstrate to markets an acute appreciation of the steps required to correct the fiscal imbalances across the Union. Equally governments must demonstrate resolve to implement the hard decisions.

Markets are impatient of government inaction and are looking for swiftly implemented solutions. However, these solutions cannot usually be implemented to the market’s timetable. Hence there is likely to be disappointment in the markets which translates to volatility.

Despite the neutral domestic interest rate outlook, renewed concerns in wholesale funding markets have seen continued strong interest from banks to raise deposits from the savings market. Term deposits rates remain very attractive relative to both current interbank market rates and those in prospect.

Borrowers continue to benefit from the stable RBA cash rate.

In addition, significantly lower longer term interest rates have sparked interest in fixed rate mortgages. In many maturities the longer term rates are below the current variable by a considerable margin.

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