Economic Update – March 2011 Glenn Baker – Chief Economic Adviser ING DIRECT At the March meeting the Reserve Bank Board left the official cash rate unchanged at 4.75% making it the third time in as many meetings the Board opted for a stable outcome. This decisi... March 02, 2011 Glenn Baker – Chief Economic Adviser ING DIRECT At the March meeting the Reserve Bank Board left the official cash rate unchanged at 4.75% making it the third time in as many meetings the Board opted for a stable outcome. This decision is consistent with the recent messages being delivered by the Reserve Bank and was almost universally expected in the market. The Reserve Bank is continuing to indicate a significant degree of comfort with the immediate outlook for inflation and interest rates, implying that the official cash rate could remain steady for some months to come. The longer term outlook, however, remains one in which there is expected to be a need to raise interest rates again to contain the potential for higher inflation as the economy moves into a stronger growth phase later in 2011. At the last official reading on inflation released in January for the year ended December 2010 the Consumer Price Index (CPI) had indicated an annual increase in prices of 2.75%. This was down from readings earlier in 2010 that were above 3%. More importantly, the underlying measures of inflation, those that strip out extraordinary items and that the Reserve Bank prefers to focus on, had fallen to around 2.25% which is at the bottom end of the range targeted by the Reserve Bank, being 2% to 3%. The Reserve Bank has made statements on a number of occasions in recent weeks and months that it expects inflation to remain consistent the target range over the year ahead. This provides considerable guidance on expectations in relation to monetary policy application as it indicates that the Reserve Bank is not seeing a need to contain inflation in the immediate period ahead. Having said that, it could be that a move to the higher end of the range over time would see a shift in attitude to ensure that inflation did not move outside of the range. It is generally expected that such a scenario will not develop in the next few months and that the cash rate will be left unchanged until at least around the middle of the year. Adding to the perception of interest rate stability has been the flooding in Queensland and Victoria and the other natural disasters that have occurred in the last month or two. These events have had, and for the immediate future will continue to have, an adverse effect on economic activity. Prices of some produce and resources have spiked due to supply disruptions but it is the Reserve Bank's practice in situations such as this is to look through the immediate effects to the medium term prospects for economic activity and prices. In this regard, it is expected that interest rate stability will prevail as the economy continues to grow at a moderate rate without any immediate concern regarding inflation. Also adding to the softer short term view of economic activity is the fact that the household sector continues to exhibit caution in relation to spending and borrowing with increases in the savings rate evident, either as savings or debt repayments. Looking at the longer term though there continues to be a picture developing whereby economic activity accelerates with price pressures emerging over time which would trigger a return to tighter monetary policy settings through further increases in the official cash rate. Australia is the beneficiary of historically high terms of trade as the prices for our commodity exports have risen to record levels. This has mainly been fuelled by the very strong growth numbers coming out of China and to a lesser degree India and the associated strength of demand for our raw materials, in particular iron ore and coal. This regional economic strength has not only provided a significant stimulus for Australia but has also kept world economic growth at higher levels while the major developed countries in Europe along with the U.S. have struggled to claw their way out of the post-GFC recession they have been gripped by. While there is still a long way to go for the major developed economies, especially in relation to weak employment growth, there are signs emerging that growth rates are steadily improving. This will ultimately add to the world growth rate. In this scenario commodity prices will remain firm for some time and Australia will continue to enjoy elevated terms of trade which will in turn drive high levels of national income. Investment is rising in response and this will also drive greater economic activity. The downside is that this bright outlook for Australia is unfolding against an already tight labour market backdrop. The unemployment rate has fallen to around 5% and any further advances in employment are likely to trigger wages pressures as skill shortages emerge and it becomes harder for employers to attract suitable workers. There have already been signs in recent months that wages growth is starting to accelerate and this trend is likely to continue. Wage increases will feed into prices which will also be growing as the result of an improving economic outlook and an elevated demand for goods and services. As we move deeper into 2011 the current benign outlook for inflation is anticipated to give way to a rising inflation scenario, albeit not an aggressive one. In this context the Reserve Bank can be expected to shift its stance on monetary policy and resume a mild tightening program to contain the emergence of inflation. Increases in the official cash rate of the order of 0.5% can be expected over the second half of the year, taking the the official cash to 5.25% by December.